Performance audit, Land Department, mineral leasing program

DOUGLAS R. NORTON, CPA
AUDITOW GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
March 10, 1992
Members of the Arizona Legislature
The Honorable F i f e Symington, Governor
Mr. M. J. Hassell, Commissioner
State Land Department
Transmitted herewith i s a report of the Auditor General, A Performance
Audit of the State land mineral leasing program. This audit was
conducted under the provisions of Session Laws 1989, Chapter 288,
Section 9.
The report evaluates the performance of the State Land Department in
enforcing the 1989 revisions to i t s mineral leasing program and the
impact of those changes. We found that the changes in royalty rates for
mines producing on State land generated an additional $ 12 m i l l i o n in
royalty payments to the State over the past four years, approximately 93
percent more than would have been collected under the old formula.
1,
However, mining economists who reviewed the appraisals for the two copper
mines producing on State land found that the appraisals were d e f i c i e n t .
The deficiencies may have led to incorrect calculation o f the State's
interest in the mines and amount o f royalty payments to the State.
My s t a f f and I w i l l be pleased to discuss or c l a r i f y items in the report.
This report w i l l be released to the public on March 11, 1992.
Sincerely,
DRN : l mn
2700 NORTH CENTRAL AVENUE * SUITE 7 0 0 . PHOENIX, ARIZONA 85004 . ( 602) 255- 4385 ' FAX ( 6 0 2 ) 255- 1251
SUMMARY
The Office of the Auditor General has conducted a review of the State
land mineral leasing program as modified by the provisions of Session
Laws 1989, Chapter 288, Section 9. The session law authorized the review
and s p e c i f i c a l l y directed the Auditor General to evaluate the performance
of the State Land Department in enforcing the provisions of the above
legislation and assess i t s economic impact.
The New Mexico- Arizona Enabling Act granted the State of Arizona more
than 10 m i l l i o n acres of trust lands to support numerous beneficiaries,
most notably public schools. The State Land Department ( under the
direction of a Commissioner appointed by the Governor) was created as a
trustee to administer these lands in a manner that w i l l produce the
largest amount of revenue for i t s beneficiaries. Although the Enabling
Act required that State lands be appraised before lease, State law did
not require an appraisal; lessees of State mineral lands paid only a
fixed royalty of 5 percent of the net value of the minerals produced.
However, in 1989, the U. S. Supreme Court ruled that the Arizona statutes
were invalid. In an e f f o r t to implement the U. S. Supreme Court decision,
the Legislature enacted new mineral leasing statutes in June 1989 that
established a minimum royalty rate of 2 percent based on the gross value
of a l l recovered minerals, and required royalties to be based on the
appraised value of the minerals located on State lands. After the
enactment of the new statute, the Department contracted for the appraisal
of the two largest copper producing mines operating on State lands.
These two mines accounted for approximately 98 percent of the royalties
collected by the Department in fiscal year 1990- 91.
Revisions To Mineral Leasina Statutes
Have Produced Sianif icant Economic Impact
To The State ( see pages 5 through 10)
The 1989 statutory change in royalty rates for mines producing on State
lands generated an additional $ 12 m i l l i o n to the State over the past four
years, approximately 93 percent more revenue than would have been
realized under the old formula. However, the impact of the statutory
change on the mining industry i s less certain. Some in the industry view
the new rate as an added cost that makes exploration or production on
State land less a t t r a c t i v e . However, industry representatives also
indicate that other factors, including mineral prices and environmental
l i a b i l i t y , affect decisions about where to explore or mine.
The De~ artment Should Ensure That Future Appraisals
Correctlv Estimate The State's Interest
In Its Mineral Lands ( see pages 11 through 18)
Under the requirements of A. R. S. $ 27- 234, the Commissioner must appraise
a l l State lands leased for the purpose o f extracting minerals. In the
case of the two largest copper producing mines, only a portion of each
mine i s located on State lands, approximately 44 percent of one and 7
percent of the second. As such, i t was necessary for the Department to
appraise the total value of each mine in order to determine the value of
the State's interest in the mine. To appraise the t o t a l value required
the Department to estimate the value of each mine's ore reserve and
establish the cost of production, including an analysis of capital
investment, capital costs and taxes.
Although Arizona realized significant additional revenues as a result o f
the 1989 revision, the methodological assumptions used by the Department
to determine the State's interest in the two largest mineral producing
mines were incorrect. A review by two mining economists ( hired to assist
us in our evaluation of the appraisals of the two mines) i d e n t i f i e d
several departures from standard appraisal techniques that affect the
value of the State's interest in these two mines. The deficiencies noted
by our consultants included the incorrect calculation of the value of the
ore reserves, unrealistic capital costs, inadequately defined taxes and
subsidies, and the inappropriate deduction of royalty payments.
ti?
These deficiencies in the appraisals have a direct impact on the
valuation of each mine and, therefore, the value of the State's interest
in each mine. While a f u l l reappraisal w i l l be necessary to accurately
determine the value of each mine and the State's interest, our
consultants estimated that the appraisal had understated the amount of
the State's interest in one mine by approximately $ 30.4 m i l l i o n , and
overstated the State's interest in the second mine by an estimated
$ 900,000. Although any estimate of the future impact these valuation
changes w i l l have on royalty collections is hampered by the limitations
of the data used in the original appraisals, we estimate that additional
royalties might have been due from both mines i f the appraisals had been
performed correctly.
Despite the problems i d e n t i f i e d with the appraisals, the Department may
not be able to modify the contracts signed with the mines. The mistakes
in the appraisal process appear to be mistakes which were accepted by the
Department. Changing the contracts with the mines because of these
mistakes would probably require the consent of the mines. Although the
Department can l i k e l y do nothing about the problems with the existing
mineral leases, i t should develop guidelines to ensure that future
appraisals correctly assess the State's interest in i t s mineral lands.
The Department should incorporate these guidelines into a l l future
appraisals.
The Department Should Ensure That Future
Adiustments To Its slid in^ Scale Rovaltv Formula re Appropriate ( see pages 19 through 22)
To determine the amount of royalties each mine should pay for the
extraction of copper ore, the Department has developed a s l i d i n g scale
royalty formula. Although the use of a s l i d i n g scale formula appears
appropriate, future adjustments to the formula should be based on
appropriate data. The Department's leases with the two largest copper
mines c a l l for an annual adjustment of the formula based on changes in
production costs of the mines. However, according to our consultants,
the production cost data used to adjust the formula includes
inappropriate costs i e , interest costs and royalty payments) which
could result in the mines paying less in royalties.
Improvements Needed For P lanninq
And Manaaement Of The Mineral
Leasina Proaram ( see pages 23 through 27)
The Department should improve i t s overall planning and management of the
mineral leasing program. Although the Department exceeded statutory
deadlines in implementing the 1989 revisions to the mineral leasing
statutes for the two largest producing mines, we found much of the delay
appears j u s t i f i e d . However, the Department's f a i l u r e to appraise the
remaining eight producing mines operating on State lands could result in
l o s t interest revenue to the State. As such, the Department can and
should strengthen planning and management for the remaining mineral
leases, p a r t i c u l a r l y the producing leases, and for future leases to l i m i t
delays in conducting appraisals and establishing royalty rates.
TABLE OF CONTENTS
Pane
INTRODUCTION AND BACKGFWND. . . . . . . . . . . . . . . . . . 1
FINDING I: REVISIONS TO MINERAL LEASING
STATUTES HAVE PROWCED S l GN I F l CANT
ECONOMIC IMPACT TO THE STATE . . . . . . . . . . . . . . . 5
Dollar Impact Of Royalty Rate Change . . . . . . . . . . . 5
Impact Of Royalty Rate On Mining Industry. . . . . . . . . 7
FINDING II: THE DEPARTMENT SHOULD ENSURE THAT FUTURE
APPRAISALS CQRRECTLY ESTIMATE THE STATE'S
INTEREST IN ITS MINERAL LANDS. . . . . . . . . . . . . . .
Appraisals Were Not Conducted According
To Standard Appraisal Methodology. . . . . . . . . . . . .
The Department Needs To Provide
Clear Direction For
Future Appraisals. . . . . . . . . . . . . . . . . . . . .
Recommendation . . . . . . . . . . . . . . . . . . . . . .
FINDING Ill: THE DEPARTMENT SHOUU) ENSURE THAT FUTURE
ADJUSTMENTS TO ITS SLIDING SCALE
ROYALTY F W L A ARE APPROPRIATE. . . . . . . . . . . . . .
Use And Appropr i ateness
Of The Sliding Scale Formula . . . . . . . . . . . . . . .
Use Of Appropriate Break- Even
Price In The Sliding Scale Formula . . . . . . . . . . . .
Recommendation . . . . . . . . . . . . . . . . . . . . . .
FINDING IV: IMPROVEMENTS NEEDED FOR PLANNING
AND MANAGEMENT OF THE MINERAL LEASE PROGFW. . . . . . . .
Implementation Impeded For
Two Largest Mines. . . . . . . . . . . . . . . . . . . . .
Improvements Needed For Planning
And Management Of Lease Program. . . . . . . . . . . . . .
Recommendations. . . . . . . . . . . . . . . . . . . . . .
ILLUSTRATIONS
Paae
CHART 1 A Comparison Of Total Income
To The State Under The
Old vs. New Royalty Formula. . . . . . . . . . .
(; RAPH A Copper Prices For The Period
From January 1980 To February 1991 . . . . . . .
TABLE 1 Estimated Value Of The State's Interest
In The Two Largest Copper Mines. . . . . . . . .
TABLE 2 State Land Department Sliding ScaleRoyalty Formula. . . . . . . . . .
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a review of the State
land mineral leasing program as modified by the provisions of Session
Laws 1989, Chapter 288, Section 9. The session law authorized the
review and s p e c i f i c a l l y directed the Auditor General to evaluate the
performance of the State Land Department in enforcing the provisions of
the above l e g i s l a t i o n and assess i t s economic impact.
Histotv And Purpose
Of Trust Lands
In 1910, the New Mexico- Arizona Enabling Act became law, allowing the
people of these t e r r i t o r i e s to form state governments. The act included
provisions that confirmed previous land grants and issued new grants
encompassing almost ten m i l l i o n acres to the State of Arizona. The
conditions attached to the granted lands require that ( 1) granted lands
could not generally be sold or leased except to the highest bidder at a
public auction following notice by advertisements; ( 2) the granted lands
could not be sold or leased for less than the value set by a required
appraisal ; and ( 3) al l proceeds from the lands would be used for the
support of numerous beneficiaries. By r a t i f i c a t i o n of the Arizona
Constitution in 1911, the Arizona electorate accepted the land grants
and conditions. State lands now encompass approximately 9.5 m i l l i o n
acres for the benefit o f numerous educational, health, and correctional
i n s t i t u t i o n s .
Role Of The
State Land Department
The Enabling Act imposed a fiduciary responsibility on Arizona regarding
State lands. In 1915, the Arizona Legislature created the State Land
Department to "... administer a l l laws relating to lands owned by,
belonging to, and under the control of the state.'' Under the direction
of a Commissioner, who i s appointed by the Governor, the Department's
primary function i s to administer Arizona's trust lands in a manner that
w i l l produce the highest revenue y i e l d for the numerous beneficiaries.
Funds from land transactions are deposited into either a permanent fund
or an expendable fund as specified in the Enabling Act. Permanent fund
revenues come from the sale of land or royal t i e s from natural products
of the land. These funds are not expendable for any purpose and are
invested by the State Treasurer in interest- bearing securities.
Expendable fund revenues include lease revenue from land leases and
permits, interest from sales contracts, and interest earned on permanent
fund investments, and are available to beneficiaries to use d i r e c t l y for
their operations.
The Department's Minerals Section, located within the Natural Resources
Division, administers the mineral leasing program. In addition to
mineral leases, the section administers prospecting permits, o i l and gas
leases, as well as mineral material leases and sales. The Minerals
Section i s also responsible for the geologic evaluation of a l l State
land sales and the economic reevaluation of a l l mineral leases.
Royalty Rates Under
Previous Arizona Statutes
Section 28 of the Enabling Act specified that State lands could not be
leased for less than their value as determined by an appraisal. Arizona
passed i t s own statute ( Arizona Revised Statutes $ 27- 234) that required
leases on State mineral lands to pay a royalty of 5 percent of the net
value(') of the minerals produced, but did not requirs those lands to be
appraised before they were leased, or require those lands to be leased
at their f u l l appraised value.
In 1980, the O f f i c e o f the Auditor General released a report on the
State Land Department ( Performance Audit Report No. 80- 3). The report
recommended adoption of a gross value royalty, as opposed to net, to
increase State royalty revenue and el iminate the accountabi l i t y problems
associated with a net royalty system.
( 1) Net value i s defined as gross value a f t e r processing, less the cost of transportation
from place of production to place of processing, the costs of processing, and taxes
on product; on.
Court Proceedinss
In 1981, a s u i t against the Department was f i l e d in the Maricopa County
Superior Court by individual taxpayers ( Kadish) and an association of
public school teachers ( represented by the Center for Law i n the Public
interest). The s u i t sought to invalidate Arizona's fixed 5 percent
royalty rate. The p l a i n t i f f s contended that the State statute
impermissibly resulted in the extraction o f minerals without payment of
the f u l l value to the State. The p l a i n t i f f s claimed that such a
l i m i t a t i o n o f income was contrary to the requirements of the Enabling Act
and the Arizona Constitution. In 1985, the Superior Court ruled in favor
of the Department.
Subsequently in 1987, on appeal by the p l a i n t i f f s , the Supreme Court of
Arizona reversed the lower Court decision, declaring the State statute
unconstitutional and void. Several mineral lessees then petitioned the
U. S. Supreme Court to review the Arizona Supreme Court decision. The
U. S. Supreme Court concluded, in a 1989 ruling, that lease of mineral
lands granted to the State of Arizona under the Federal statutes must
substantial ly conform to the mandatory requi rements of the Enabl ing Act,
and the Arizona Supreme Court was correct in declaring the Arizona
statutes invalid.
1989 Mineral Leasing Statute
@
In an e f f o r t to implement the U. S. Supreme Court decision, the
Legislature repealed A. R. S. 327- 234 and enacted new mineral leasing
statutes in June 1989 ( Session Laws 1989, Chapter 288). The new statutes
require an annual land rental as well as a royalty fee o f a t least 2
percent based on the gross value of a l l recovered minerals. The royalty
rate for each mineral lease must be the appraised value of the State's
interest in each mine, and expressed as a percentage of the gross value.
In September 1989, the Department began to develop procedures for
implementing the new law and contracted for the appraisal of the two
largest copper mines operating on State lands. However, because only a
portion of each of the two copper mines i s located on State lands
( approximately 44 percent of one and 7 percent of the second), i t was
necessary for the Department to appraise the t o t a l value of each mine in
order to determine the value of the State's share or interest in the
mine. These two mines accounted for approximately 98 percent of the
royalties collected by the Department in fiscal year 1990- 91.
Audit Scope And Methodolow
The scope of our audit i s defined by Session Laws 1989, Chapter 288,
Section 9:
The auditor general shall review the status of mineral leasing on
s t a t e t r u s t lands. The review and report shall include: 1) the
performance of the state land department in enforcing the
provisions of t h i s act, 2) the economic impact of t h i s act.
To accomplish t h i s directive, our audit contains findings in the
following areas:
the economic impact of the 1989 revisions to the mineral leasing
statutes;
the techniques used to appraise the State's share of two copper mines;
the Department's use of a s l i d i n g scale formula to collect royalties
from mineral leases; and
planning and management of the mineral lease program.
To further assist us in our review of the appraisals of the two largest
copper mines and the s l i d i n g scale royalty formula, we retained the
mining economics consulting f i r m o f Newcomb and Harris. Drs. Newcomb and
Harris have over 24 years' experience in mineral appraisal, materials
markets, and the evaluation of mineral resources and reserves. The
consultants' assessments and recommendations are presented throughout
Findings II and I l l .
This audit was conducted in accordance with government auditing
standards.
The Auditor General and s t a f f express appreciation to the Commissioner
and s t a f f of the State Land Department for t h e i r cooperation and
assistance during our audit.
FINDING I
REVISIONS TO MINERAL LEASING STATUTES HAVE
PRODUCED SIGNIFICANT ECONOMIC IMPACT TO THE STATE
The 1989 statutory change in royalty rates to mines producing on State
land has generated an additional $ 12 m i l l i o n to the State. Over the past
four years, the new royalty formula has generated approximately 93
percent more revenue than would have been realized under the old
formula. However, the impact on the mining industry i s less certain.
Some in the industry view the new rate as an added cost that makes
exploration or production on State land less a t t r a c t i v e . Industry
representatives also indicate that other factors affect decisions about
where to explore or mine.
Dollar lrn~ act Of
Rovaltv Rate Chanse
The new royalty rate has greatly impacted c o l l e c t i o n o f revenues from the
two major copper producers on State land. Although only two mines have
been charged the new rate, payments to the State over the past four years
have nearly doubled. Because the p r i c e o f copper is now considered in
the royalty formula, much of this increase i s due to higher than average
copper prices in recent years.
Revenue contribution of two copper producers - While the 1989 statutory
revisions and the resulting royalty rate change affect a l l mineral leases
on State lands, two copper mines, the Asarco Mission Mine and the Magma
San Manuel Mine generate most of the royalty revenue. For example, in
fiscal year 1990- 91, Asarco contributed approximately 72 percent and
Magma more than 25 percent to the total royalties collected by the
Department.
Increase i n royal tv income - Asarco's and Magma's royalty payments have
increased almost 93 percent over the past four years as a result of the
new royalty rate. Chart I ( page 6) shows that from 1988 through 1991
royalties collected from these companies were s i g n i f i c a n t l y higher than
they would have been under the old formula. For example, in fiscal year
1988- 89, under the old royalty rate the two mines generated revenues of
$ 4.7 m i l l i o n ; under the new royalty rate, they generated revenues of $ 9.8
m i l l i o n , an increase of 106 percent. In t o t a l , over the past four years,
the State has collected additional revenue of approximately $ 12 m i l l i o n
from the two mines under the new royalty rate.
Role of comer orices - Because the new s l i d i n g scale formula takes
copper prices into account in determining the mines' royalty rate, when
copper prices increase, royalties increase. As Graph A ( page 8)
indicates, copper prices have fluctuated s i g n i f i c a n t l y in the past ten
years, ranging from a low of 61 cents per pound in August 1986 to a high
of $ 1.60 per pound in December 1988. Additionally, the p r i c e o f copper
per pound f e l I below $ 1 from August 1980 to October 1987. However,
because prices have been higher over the past four years, the two mines'
royalty payments have exceeded the minimum 2 percent of gross established
by statute. Asarco contributed an average of 5.65 percent of gross from
December 1987 through December 1990, wh i l e Magma con t r i bu ted an average
of 3.7 percent of gross from December 1987 through Apri l 1991.
Conversely, had copper prices been lower during that period, royalty
payments from both mines would have been closer to the statutory minimum.
Impact Of Rovaltv Rate
On Minina lndustw
The mining industry representatives we interviewed perceive the new
royalty rate as an increase in the cost of mining on State lands.
Therefore, they are reluctant to invest in sites on State lands because
they fear their p r o f i t s w i l l be eroded by the new rate. Delays by the
Department have made assessing the impact of the rate increase
d i f f i c u l t . Although factors such as mineral prices and environmental
l i a b i l i t y also contribute to the cost of mining, the mines are focusing
on the impact of the new rate.
Perce~ tionso f the m i n i n ~ in dustry - Companies mining on State lands are
unhappy with the new royalty formula and say i t has increased the cost of
their operations on State lands. One industry spokesman called the
new rate the " ki l l ing of the golden goose." The new 2 percent of gross
method i s perceived as an " unknown" by industry re, resen tat i ves because
the unpredictable future price of copper plays such an important role in
the new royalty formula. However, according to a Department o f f i c i a l ,
the new royalty rate, once established, i s very precise, whereas the old
rate could be more easily manipulated by the mines.
According to several mining o f f i c i a l s , the result of the new royalty rate
may be a decrease in prospecting and exploration on State lands. These
o f f i c i a l s contend that, given a choice, a company would choose to mine on
private or Federal lands rather than State lands because royalty rates on
private lands are established prior to exploration and, therefore, are
set before mining occurs. Consequently, the price o f copper has no
impact on the rates paid. Further, because mining on Federal lands does
not require the payment of royalties, mining there costs less.
Finally, we spoke with four companies with production capabilities on
State lands. Each company considers the new royalty rate an important
factor in i t s decision to develop on. these lands. While factors such as
mineral prices also play a role, one company o f f i c i a l said that in their
market analysis they need to know that the mineral potential on State
lands i s enough t o o f f s e t the higher royalty rate.
Delavs bv the De~ artment - The mining industry's concerns about the new
royalty rates have been affected by the Department's f a i l u r e to complete
timely appraisals of a l l mines operating on State lands. As explained in
Finding IV ( page 23)) because of delays in mine appraisals by the
Department, the impact of the new royalty rate i s d i f f i c u l t to measure.
Until more mines have been appraised, the total impact of the new royalty
rate on a l l the mines affected cannot be determined.
Other considerations i n decidinq where and when to mine - While the
royalty rate influences the mines1 decision to develop State lands, other
factors also have an impact. Mineral prices, environmental protection,
l i a b i l i t y cosiderations, and the general state of the economy a l l
contribute to the potential prospecting and development equation. Mining
industry o f f i c i a l s c i t e the price of copper and other minerals as factors
that are as important as the royalty rate in determining whether to
initiate development of mines on State lands. Further, according to a
Department official, stricter environmental controls increase mining
costs significantly. Because mines are financially liable for cleaning
up all environmental damage caused by their activities, clean- up costs
can substantially affect the potential profitabi l i ty of a mine. Final ly,
mining industry officials mentioned several other important factors they
consider before deciding to mine a particular mineral deposit. These
factors include the general state of the economy, labor and facility
operations costs, the demand for the mineral, the qua\ ity of the deposit,
and the ease of extraction.
FINDING II
THE DEPARTMENT SHOULD ENSURE THAT FUTURE APPRAISALS
CORRECTLY ESTIMATE THE STATE'S INTEREST
IN ITS MINERAL LANDS
Although Arizona has realized significant additional revenue as a result
of the 1989 mineral leasing revisions, the methodological assumptions
used to appraise the State's interest in mines operating on State lands
were incorrect. Our review revealed several departures from standard
appraisal techniques that s p e c i f i c a l l y a f f e c t the value of the State's
interest. The Department should develop guidelines to ensure that
assumptions made in future mineral appraisals do not incorrectly reduce
royalty payments to the State.
Appraisals Were Not Conducted Accordinq
To Standard Ap~ raisal Methodolocry
Appraisals of the two largest copper mines operating on State lands did
not include the use of several standard appraisal techniques. According
to A. R. S. $ 27- 234, the Commissioner i s required to conduct appraisals
according to standard appraisal methodology to establish the value of the
State's interest in a l l minerals recovered on State lands. With the aid
of consultants, we identified several deficiencies in appraising the
State's interest. These deficiencies impact the value of the State's
interest and the amount of royalty collected by the Department.
Appraisal reauirements - Under the new mineral leasing statutes enacted
in 1989 ( A. R. S. $ 27- 234), the Commissioner must appraise a l l State lands
leased for the purpose of extracting minerals. The appraisal i s intended
to establish the value of the minerals contained on these lands, and i s
then used to determine a royalty rate that w i l l obtain the f a i r value of
the minerals from the mining companies leasing the lands.
Ap~ raisal of two mines - Although numerous mineral leases have been
issued by the Department, the majority of the mineral royalty revenue
collected by the Department is derived from only two leases.(') These
( 1) These two leases accounted f o r approximately 98 percent of the royal t i e s collected by
the Department i n f i s c a l year 1990- 91.
two leases include State lands that represent a portion of two large
copper mines, the Asarco Mission Mine and the Magma San Manuel ~ i n e . ( l )
The Department contracted with a mining engineer to appraise the value of
the minerals contained on the State lands leased by these two mines. In
conducting the appraisals, the Department's appraiser determined that
since only a portion of each of the two mines i s located on State lands,
i t was necessary to appraise the total value of each mine in order to
establish the value of the minerals located on the State lands leased to
the mines. In doing so, the appraiser established both a total value of
each mine as well as the value of the State's interest in each mine
( i . e., value of the minerals contained on the State lands when included
as a portion of the total value of the mine.) To determine the total
value of the mines, the Department's appraiser established the present
value of each mine's expected cash flows ( or income minus costs) over the
expected l i f e of the mine. To accomplish this, the appraiser estimated
the value of each mine's ore reserve and established the cost of
production, which included analysis o f capital investment, capital costs
and taxes. The State's interest in each mine was determined by
estimating the value of the royalties the Department could collect from
the minerals contained on State lands, using a fixed royalty rate o f 5
percent of the net value of the minerals.
Appraisal deficiencies - Several deficiences l i m i t the accuracy of the
appraisals conducted on the two largest copper mines operating on State
lands. We found the appraisal methods u t i l i z e d by the Department's
appraiser were i n s u f f i c i e n t to accurately determine the State's
interest. Several deficiencies were noted by our consultants, including
the f o l lowing:
Ore Reserves Incorrectly Calculated - The Department ' s appraiser
incorrectly estimated the value of the ore reserves by ( 1) using a
constant copper price with a fixed estimate of the size of the ore
reserve, and ( 2) using constant production costs based solely on a
one- year period. However, the value of the metals in the ore
reserves does change with price and cost, both of which vary widely
( 1) The Asarco Mission Mine i s an open p i t mining operation, approximately 44 percent of
which i s located on State lands. The Magma San Manuel Mine i s an underground mining
operation, of which approximately 7 percent i s located on State lands.
from year to year. In addition, it i s unlikely that cost would
remain constant i f production were to increase. Furthermore, a
one- year period does not provide s u f f i c i e n t history for evaluating
the changes in price and cost. Since the value of the ore body i s
based on the results of simulations using a range of values, the
assumption of constant prices and costs for such a limited period
does not provide an accurate basis for valuing the ore body. Our
consultants recommend that the Department review mine information
( prices and cash flows, tonnages, outputs) periodically so deviations
from appraisal estimates can be made an integral part of analysis,
thereby increasing the accuracy and consistency in calculating the
State's interest and mine value.
State's Interest lncorrectlv Calculated - The Department ' s apprai ser
failed to adequately determine the value of the State's interest.
The appraiser established the State's interest in each mine by
estimating the value of the royalties the Department could collect
from the minerals contained on State lands, using a fixed royalty
rate of 5 percent of the net value of the minerals. Our consultants
recommend valuing the State's interest as a net present value after
the mines' costs, excluding royalties, are deducted.
Validity of Price- Cost Estimates Uncertain - The Department ' s
appraiser did not s t a t i s t i c a l l y test the appropriateness of either
his pricing forecasts or cost estimates, nor did the appraisal
contain the information necessary to conduct these tests. Since
price and cost estimates are judgmental in forecasting, tests f o r
consistency or significance must be performed. Our consultants
recommend ( 1) including tests o f p r i c e significance, such as a short
run, five- year moving average, forecast model in appraisals, and ( 2)
modifying the costing approach to e x p l i c i t l y identify key costs and
l i n k them to database simulations.
Misstatement of Caoital Investment - Cap i ta l investment was misstated
in three s i g n i f i c a n t ways. F i r s t , i n i t i a l capital less depreciation
was not included i n calculating the t o t a l investment i n either mine.
Second, in valuing the Magma mine, the appraisal included the cost of
refurbishing processing f a c i l i t i e s that do not s o l e l y pertain to the
State's interest. Third, the appraisals did not completely report or
document net investment, depreciation, and depletion charges used in
cash flow analysis. Without this e x p l i c i t information, the appraisal
cannot accurately determine the net value of the mines.
Cost of Capital Unrealisticallv Hiqh - The cost of capi t a l used in the
appraisal i s not related to the industry and the mines' financial
experiences. The appraisal used a subjective discount rate(') of 17
percent for both mines, which included a 7 percent p r o f i t margin.
According to our consultants, i t i s very unlikely that
( 1) The discount rate i s defined as the i n t e r e s t rate used to calculate the present value
of a specific pattern of cash flows less the rate of i n f l a t i o n . At a minimum, without
uncertainty or risk of default, the rate should be set a t the risk- free i n t e r e s t r a t e
less the expected rate of i n f l a t i o n .
the mines could sustain a real 17 percent cost of capital over a
ten- year period as assumed by the appraisal. Our consultants estimate
that the real discount rate i s closer to 13.4 percent for Asarco and
14.4 for Magma.
8 Taxes and Subsidies Inadequately Defined - The appraisal used
effective tax rates(') rather than code tax rates. The effective tax
rate i s unrealistic because i t disguises information important to the
lessor about revenue, royalty, and depletion. The effective tax
rate, unlike the code tax rate, can vary annually, which makes i t
unauditable. To correct these deficiencies, our consultants
recommend that tax options and deductions be incorporated into the
cash flows by the use of an accounting program s p e c i f i c a l l y developed
for mining operations.
8 Inappropriate Deduction of Royalty Payments - The in i t i a l apprai sa l s
inappropriately deducted royalty payments from the cash flows in
determining the value of the mines. The purpose of the appraisal i s
to determine an appraised basis against which royalties w i l l be
assessed. Therefore, deducting royalty payments as a cost
incorrectly reduces the value of the State's interest in the ore body.
Im~ act on mine value, State interest. and cost of production - The
appraisal deficiencies noted above d i r e c t l y impact mine valuation, the
State's interest, and the mine's cost of production. Our consultants
attempted to measure the total impact of these appraisal deficiencies.
However, their e f f o r t s were limited to using the same information used by
the Department's appraiser. To accurately determine the mine's value and
the State's interest, a f u l l reappraisal must be performed.
In estimating the impact of the appraisal deficiencies for each mine, our
consultants broke down costs shown in the appraisal and simulated cash
flows under a correct model. Correction of the deficiencies i s made
progressively in three steps. As shown in Table 1 ( page 15), the
individual impact at each stage is estimated as well as the combined
impact of the deficiencies on the value of the State's interest.
( 1) The e f f e c t i v e tax rate i s a weighted average that sununarizes the net e f f e c t of various
taxes and deductions so that i t i s an aggregate of those individual changes.
TABLE 1
Estimated Value Of The State's
Interest In The Two Largest Copper Mines
Department Appraised Value
Effect Of Appraisal Corrections
on Appraised Value
Step 1: Incorporating estimates of
the i n i t i a l capital, defining
taxes, and subsidies, and
correcting the calculation o f
the State's interest.
Step 2: Adjusting the cost of capital
from 17 percent to 13.32 percent
and 14.40 percent, respectively.
Step 3: Restoring the deduction of
royalty from revenues.
Estimated Appraised Value
After Correction of
Appraisal Deficiencies
TOTAL DIFFERENCE
Source:
Asa r co h g m
( millions) ( millions)
$ 20.0 $ 3.0
Office of the Auditor General, s t a f f analysis of data
obtained from our consultants' report.
As shown in Table 1, for Asarco, adjustments increase the corrected
State's interest to $ 50.4 m i l l ion, $ 30.4 mi l l ion ( or approximately 150
percent) more than the Department's appraised value. For Magma,
adjustments reduce the corrected State's interest to $ 2.1 mi l lion, $. 9
mi I l ion ( or 30 percent) less than the Departments appraised value.
These changes also affect the mines' cost of production. The net effect
on Asarco's cost of production i s an increase of one cent above the
Department's value. The net effect on Magma's cost of production i s a
significant reduction of approximately 26 cents.
Im~ act on royalty receipts - The appraisal deficiencies can impact the
amount of royalty collected by the State. While the net effect on
current royalty payments cannot be determined accurately without a f u l l
reappraisal, changes in the appraisal values clearly have the potential
to impact royalty receipts. The change in the appraised value at Asarco
w i l l impact the amount of royalty to be collected. As the royalty
formula was developed to collect the State's appraised value, an
estimated increase in the State's value at Asarco would mean additional
royalty w i l l have to be collected to ensure the State's interest i s
recovered. Furthermore, due to the decrease in Magma's cost of
production, a c r i t i c a l element in the new royalty formula, the State
could potential ly col lect more royalty under the new formula than i t did
under the old formula despite the reduction in the value of the State's
interest.
The Department Needs
To Provide Clear Direction
For Future Appraisals
The Department needs to more clearly define assumptions used in
appraisals of State mineral lands. Although the Department may lack the
a b i l i t y to r e c t i f y the deficiencies of the appraisals on the Asarco and
Magma mines, i t can establish guidelines to be used in future appraisals.
Masma and Asarco a ~ ~ r a i s a sl sta nd - Despite the problems identified with
the Magma and Asarco appraisals, the Department probably cannot modify
the contracts signed with the mines. The lease i s a separate document
from the appraisal and i s a contract between the State and the mines.
According to our General Counsel and the Assistant Attorney General who
represents the Department, the Department appears to have no legal basis
for changing the contract even though the assumptions used by i t s
appraiser do not conform to the statutory requirement for standard
appraisal methodologies.
The Department's actions in accepting the contract l i m i t i t s a b i l i t y to
modify i t after the fact. Department s t a f f raised questions about some
of the appraiser's assumptions during their review. However, these
questions were dismissed and the Department used the appraisal as the
basis for contract negotiations with the mines. Thus, any mistakes i n
the appraisal process appear to have been accepted by the Department and
do not appear to provide the basis for changing the contracts. Under
these circumstances, any change in the contracts would probably require
the consent of the mines.
Guidelines for future a ~ p r a i s a l s - Although the Department may not be
able to address the problems with the existing mineral leases, i t can
develop guidelines to ensure that future appraisals correctly assess the
State's interest in i t s mineral lands. Guidelines are needed to further
define areas of standard appraisal methodologies that are open to
interpretation.
A. R. S. 927- 234 requires the Department to appraise mineral lands using
standard methodology. The Department used a standard methodology, the
income approach, in appraising the State's interest in the Asarco and
Magma mines. However, i t did not direct i t s appraiser in making
assumptions in areas that are not clearly defined by standard appraisal
methodology. As a result, the appraiser used assumptions that
incorrectly reduced the State's interest by approximately $ 30 mi l I ion in
the Asarco mine and overstated i t s interest by an estimated $ 900,000 in
the Magma mine ( see pages 14 through 16).
To avoid future appraisal deficiencies, the Department should c l a r i f y how
appraisers should use assumptions in appraising State mineral leases.
The Department should identify ambiguous areas within standard appraisal
methodologies, evaluate their potential impact on the State's interest in
i t s mineral lands and specify how uncertainties should be resolved to
ensure that appraisals correctly identify the State's interest. The
Department should incorporate these guidelines into a l l future appraisal
contracts.
RECOMMENDATION
The Department should develop procedures to ( 1) ensure that standard
appraisal techniques are applied to enhance the accuracy of the State's
interest and mines' cost of production calculation and ( 2) provide clear
guidance to appraisers in using assumptions in appraising State mineral
lands .
FINDING Ill
THE DEPARTMENT SHOULD ENSURE THAT FUTURE ADJUSTMENTS
TO ITS SLIDING SCALE ROYALTY FORMULA
ARE APPROPRIATE
The Department's use of a s l i d i n g scale formula to establish royalty
rates for State mineral leases appears appropriate; however, an
appropriate break- even price should be used in the formula in a l l future
lease agreements.
Use And Appropriateness
Of The Slidinu Scale Formula
The Department developed a s l i d i n g scale formula to determine royalties
for the two largest copper mines operating on State land. This method
appears appropriate for establishing royalties due the State.
Develoment of the s l i d i n q scale formula - To determine the amount of
royalties each mine should pay for the extraction of copper ore, the
Department has developed a s l i d i n g scale royalty formula. The Department
concluded that h i s t o r i c a l l y copper prices have ranged from well below the
average cost of domestic production to highs that y i e l d net p r o f i t s over
100 percent for e f f i c i e n t producers. Because of the uncertainty
established by the fluctuating p r i c e o f copper, the Department decided
that establishing a s l i d i n g scale royalty formula would be more equitable
to the State and the mines than a fixed royalty rate.
In practice, the s l i d i n g scale formula provides the minimum statutory
royalty of 2 percent of gross when copper prices result i n revenues that
are at or below the mines' production cost, defined by the Department as
the " net present value break- even price". The maximum royalty,
established by the Department at 8 percent of gross, i s the cap of the
s l i d i n g scale and i s applied when copper prices reach or exceed the
highest price experienced in the preceding 178 months. When copper
prices are between the break- even price and the highest price, the
royalty percentage rate i s calculated by using the following formula:
Royalty rate = [( Copper index price - break- even price) x mu1 ti pl i e r l + minimum royal t y
For example, with a break- even p r i c e o f $ 0.80 per pound and a high price
of $ 1.50 per pound, the formula would produce the royalty rates shown in
Table 2.
TABLE 2
STATE LAND DEPARTMENT
Sliding Scale Royalty Formula
Royalty rate = [( Copper index price - .80) x . 0 8 5 7 ( ~ ) 1 + .02
Cooper Index Price Rovalty Rate
( a) The m u l t i p l i e r i s the factor necessary to determine the royalty rate when copper
prices are between the break- even price and the highest price, and i s calculated as
follows:
Maximum royalty rate - Minimum royaltv rate 8% - 2% .0600
-. - -- -- - =. 0857
Highest price - Break- even price 1.50 - .80 .700
Source: O f f i c e o f theAuditor General, s t a f f a n a l y s i s o f d a t a o b t a i n e d
from the State Land Department.
The calculated royalty rate is then applied each month to the gross value
of the mineral concentrates the mine produces from the State lands to
determine the monthly royalty due.
Sl idina scale appears appropriate - According to our consultants, the
Department's use of a s l i d i n g scale royalty appears to be an appropriate
method of determining royalties. Other possible methods of determining
royalties, s p e c i f i c a l l y those that might appear similar to a fixed
severance tax, have been c r i t i c i z e d for d i s t o r t i n g the efficiency of
private industry decisions about the amount of time to mine or how much
to mine and invest in a g iven depos i t . This i s because severance taxes,
and the costs they create, affect the mine's level of production.
Conversely, taxation based on a producer's net income i s preferred by
both economists and the mining industry because i t does not so d i r e c t l y
influence production levels and, therefore, has l i t t l e or no impact on
the mines efficiency and the time necessary to exhaust the deposit. As
such, the Department's royalty rate formula, as a low minimum severance
plus a progressive royalty levied on net income, i s closer to an income
tax and preferable to other methods that approximate a severance tax.
Use Of Appropriate Break- Even
Price In The Slidinq Scale Formula
Although the s l i d i n g scale formula appears to be an appropriate method of
determining royalties, future adjustments to the formula must be based on
the appropriate break- even price. The Department's leases with the two
largest copper mines c a l l s for an annual modification of the formula.
However, the data used for the modifications is inappropriate and can
result in a reduction in royalties to the State.
Lease aareements - The current leases negotiated between the Department
and the two largest copper mines include provisions that allow for annual
adjustments of the s l i d i n g scale formula based on changes i n production
costs of the mines. This production cost data i s derived from the mining
companies' annual tax reports to the Arizona Department of Revenue.
Inappropriate adiustment of the formula - According to our consultants,
the use of annual production cost data computed by the mining companies
cannot be substituted for the net present value break- even price
determined by the appraisal. As discussed in Finding II ( pages 12
through 14), certain costs ( i . e., interest costs and royalty payments)
should be excluded when appraising the net present value of the mines.
Production cost data derived from annual tax reports to the Arizona
Department of Revenue w i l l include the types of costs that should be
excluded from the appraisal. By using t h i s data annually to adjust the
mines break- even price, the Department w i l l be including costs that are
not representative of the mining companies' investment in the mine.
Annual adjustments to the s l i d i n g scale royalty formula based on
production cost data could reduce the State's collection o f r o y a l t i e s .
Because the accounting methods often include capital charges not d i r e c t l y
associated with the mines' a c t i v i t i e s , a break- even price based on these
costs could be s i g n i f i c a n t l y higher than a break- even price derived from
the net present value appraisal. Therefore, since the s l i d i n g scale
formula ( see page 20) uses the mines' net present value break- even price
to determine the minimum royalty payment, any increase of t h i s price
would tend to result in the mines paying less in royalties.
Although the use of inappropriate cost adjustment data may reduce the
State's r o y a l t y c o l l e c t i o n s , the Department does not appear to have any
option to modify the leases with the two mines. As noted i n Finding I
( see pages 15 through 16), the Department i s bound by the lease
agreements signed by the mines and has no basis to u n i l a t e r a l l y change
the terms of those leases. Therefore, any action to ensure that only
correct data i s used in annual adjustments to the s l i d i n g scale must be
limited to future lease agreements.
In any future mineral lease agreements, the Department should not allow
adjustments to the s l i d i n g scale formula based on annual production costs.
FINDING IV
IMPROVEMENTS NEEDED FOR PLANNING AND MANAGEMENT
OF THE MINERAL LEASE PROGRAM
The Department should improve i t s overall planning and management of the
mineral lease program. Although the Department exceeded statutory
deadlines in implementing the 1989 revisions to the mineral leasing
statutes for the two largest producing mines, much of the delay appears
j u s t i f i e d . However, the Department can and should improve i t s
performance in implementing the statutes for the remaining leases.
lrn~ lernentation lrn~ eded For
Two Larqest Mines
For the two largest copper mines operating on State lands, the Department
has taken longer than had been allowed by statute to implement the new
mandated royalty rate. While the statutory deadline for compliance may
have been u n r e a l i s t i c a l l y short, other factors impeded completion of the
lease appraisals and revision o f the royalty rate.
Statutory deadline too short - The new legislation allowed the Department
180 days after June 8, 1989, to appraise mines and set royalty rates.
However, to ensure that t h i s legislation was adequate, the Department had
to wait for a ruling by the Maricopa County Superior Court. On
October 10, 1989, the Court ruled that the provisions of the new
l e g i s l a t i o n corrected the defects in the old statute and conformed to the
U. S. Supreme Court decision, and that leases then in effect were valid.
Thus, following the court ruling, the Department had approximately 80
days remaining in which to comply with the mandated changes. It would
appear that t h i s delay in beginning the appraisal process was beyond the
Department's control and that the statutory deadline may have been
u n r e a l i s t i c .
Other factors hamper implementation - The time required to retain an
appraiser, appraise the mines, and develop a new royalty rate formula
slowed the Department's implementation of the new mineral lease law. For
the two largest copper mines, instead o: six months, i t took
approximately twenty months.
The Department's decision to contract for the appraisal of the two
largest producing copper mines also caused delays. While the Department
reports i t began working on requests for proposals for the appraisals the
day a f t e r the Superior Court ruling, the procurement process through the
State's Purchasing Office took approximately three months to complete.
Our review of the procurement process did not uncover any specific delays
that appeared unreasonable.
In addition, the requests for proposals to conduct appraisals for the two
largest copper mines indicated the contractor would have 120 days to
complete the appraisals. While the i n i t i a l appraisal reports were
completed within the contract time frame, revisions were made after
discussions among the appraiser, the ? epartment and the mines. These
* evisions took an additional three months to complete. Therefore, i t
took approximately seven months from the time the contract was awarded
u n t i l revisions were completed.
The development of an innovative s l i d i n g scale formula for calculating
the new r o y a l t y r a t e required additional time. The Department's new
s l i d i n g scale formula uses the mines' break- even price as a variable on
the s l i d i n g scale. We conducted a survey of eight other states and found
that none had developed a method similar to Arizona's. We also reviewed
industry l i t e r a t u r e and found no comparable formula had been established
that the Department could have u t i l i z e d .
Once the formula was developed, i t s specific parameters were discussed
with and accepted by the two mines. To complete the t o t a l negotiation
process ( i . e . , from appraisal completion to agreement on the formula as
well as other lease terms) took three months for one mine and nine months
for the other.
lm~ rovements Needed For Planning
And Manaaement Of Lease Prosram
The Department should strengthen i t s planning and management procedures
for the remaining mineral leases and for a l l future leases to l i m i t
delays in the appraisal of mines and establishment o f royalty rates. A t
the present time, although there are a substantial number of mines that,
under the law, must also be appraised, the Department has not established
a plan or procedures for addressing these appraisals. Delays in the
implementation of the new royalty rate could result in the loss of
interest to the State in the future.
Additional a ~ ~ r a i s a linsc om~ letea nd untimely - In addition to appraisals
of the two largest producing copper mines, appraisals are required for
nine other producing and eighty- nine nonproducing mines. Because of the
anticipated cost to the mines to contract for these appraisals('), the
Department decided to conduct these appraisals using i t s own s t a f f .
However, the Department has not completed these appraisals in a timely
manne r .
To date, of the remaining nine producing mines, the Department has
completed the appraisal of only one. The other eight producing mines
have s t i l l not been appraised more than two years after the statutory
deadline, although they accounted for nearly $ 91,000 of the royalties
collected by the Department in fiscal year 1990- 91. ( According to the
Department, some appraisal work has been completed on three of these
eight mines.) The Department has also i d e n t i f i e d four nonproducing mines
that could begin production in the near future. Although appraisals have
not been completed on any of these mines, work has begun on only two of
them.
The Department has also not completed appraisals on most of the
nonproducing mines. To date, appraisals of only fourteen of the
eighty- nine nonproducing mines have been completed. The Department's
( 1) A. R. S. 527- 234. E provides that the costs of the appraisals should be charged t o the
mines .
goal i s to complete a l l remaining appraisals by the end of 1992. The
impact of such a s i g n i f i c a n t change i n p r i o r i t i e s on the Department's
other workload i s unclear.
Areas for improved ~ l a n n i nan~ d manaaement - There are several areas in
which improvements in planning and management could f a c i l i t a t e the
completion of the remaining mine appraisals. P r i o r i t i e s must be
established to ensure the timely completion of the appraisals of
producing mines. In addition, the Department's procedures for
implementing the program should be improved.
The Department has f a i l e d t o appropriately p r i o r i t i z e the completion of
the unappraised mines. For example, i n i t i a l l y two employees were
assigned to complete the mineral abstracts for the appraisals of
nonproducing mines while only one employee was assigned to complete the
abstracts for the producing mines. However, only producing mines
generate royalties. Further, because of the time the one employee needed
to devote to the two largest producing copper mines, only one of the
remaining nine producing mines has been appraised, while fourteen of the
nonproducing mines have been appraised.
The Department also needs to review the adequacy of i t s appraisal fees
for appraisals conducted by s t a f f . The statute specifies that the cost
for appraisals should be assessed to the mine owners. The Department
o r i g i n a l l y estimated that a charge of $ 250 per appraisal would be
adequate. This charge i s based on 20 hours of s t a f f time to complete the
appraisal. However, the Department does not monitor the amount of time
required to complete an appraisal to determine whether t h i s charge is
adequate .
Interest could be lost - Delays in the implementation of the new royalty
rate could result in lost interest to the State. Because the Department
has not appraised the remaining eight producing mines, the new royalty
rate has not been applied to the minerals recovered from these State
lands. Although the Department can collect any additional royalties,
based on the new royalty rate, retroactively to December 1987 for leases
then in effect, the State cannot earn interest for the beneficiaries
until the royalties are collected. Further, there are no provisions in
the statute for the Department to collect back interest from the mines.
RECOMMENDATIONS
1. The Department should expedite the completion of appraisals for
producing mines to minimize interest lost to the State either by
placing a higher priority on staff time or contracting appraisals.
2. The Department should develop a procedure to review on an annual
basis the adequacy of charges for staff appraisals.
Arizona
FIFE SYMINGTON
* GOVEFlNOR
1616 WEST ADAMS
PHOENIX, ARIZONA 85007
M. J. HASSELL
STATE LAND COMMISSIONE9
March 5, 1992
Douglas R. Norton
Auditor General
Office of the Auditor General
2700 North Central Avenue, Ste. 700
Phoenix, Arizona 85004
Dear Mr. Norton:
The following comments are offered concerning the Auditor
General's report on the state ~ ineral Leasing Program.
Findins I: Revisions to Mineral Leasins Statutes that
Produced Sisnificant ~ conomic Impact to the State.
The Department agrees with Finding I of the report which
describes the impacts of the $ 12 million increase in revenue in a
four year period to the Trust and the potential disincentive to the
industry accruing from the statutory change.
We were somewhat disappointed that the report did not make a
more comprehensive review of all of the 1989 changes in the mineral
leasing statute. We believe that several of these changes,
including the discretionary right to deny prospecting permits, the
right to auction unleased mines and mineral properties, index
pricing of gross mineral content, and the right to reappraise if
new minerals are discovered or mine technology changes, will have
major long term impacts on the program, and are significant
components of the new mineral leasing statute that were not covered
in the report.
Findins 11: The Department Should Ensure that Future
Appraisals Correctlv Estimate the State's Interest in it's Mineral
Lands.
The Department agrees with Finding I1 of the report and with
the recommendation of Finding I1 which calls for the Department to
develop procedures to ensure that standard appraisal techniques
Douglas R. Norton
March 5, 1992
Page 2
are used to enhance the accuracy of the State's interest and mines8
cost of production calculations, and to provide clear guidance to
appraisers in using assumptions in appraising state mineral lands.
There is apparently a fundamental disagreement between the State
Land Department and the Auditor General about what should be
appraised. A. R. S. 234- B, the new mineral leasing statute,
identifies the State's interest as the value of the royalty income
stream. It is not a percentage of the mine value or residual value
of the ore body as the Auditor General's report suggests.
The Department's appraiser defined the State's interest as the
net present value of the royalties received. We believe that this
is an appropriate definition consistent with the statute. The
appraisals of the State's interest in the two major copper mines on
Trust lands used this definition and were completed using standard
appraisal methology and rational assumptions.
A second requirement of the Department's appraisal contract
was to appraise the total mine. However, it is not necessary to
determine the value of the State's interest as the report suggests.
The value of the entire mining operation was determined in order to
assess the impacts any given royalty rate would have on the
economics of the mine, to establish costs consistent with the
economy of scale, and to determine the value of the mine to the
lessee.
The Department did not mistakenly accept these values as the
Auditor General's report suggests, but accepted the values as a
viable factor to be used in negotiating royalty schedules for the
mines as required by the statute. The mine appraisals provided
valuable information used by the Department in negotiating the
sliding scale royalty.
We believe that Finding I1 of the report misses the mark
because it focuses on an analysis of the mine appraisals, and the
net present value of the ore bodies. We recognized that the
appraisals could have been improved in some areas, but they were
sufficient for our purpose. Perhaps the best way to illustrate
what we are trying to say is to use the analogy of a building.
If the owner could sell a building, it would be vital to know the
value of the building. However, if the owner is precluded by law
from selling the building and can only rent the building, his
primary objective would be to determine a fair market rent.
Douglas R. Norton
March 5, 1992
Page 3
In the case of the mines, the State is precluded by law from
selling its mineral interest. The royalty, therefore, like a
building rent, is the only way that the State can capture its
interest. We believe that the $ 23.5 million in royalties we have
received from the ASARCO and Magma mines during the past four years
has already captured a major share of whatever appraised value is
assigned to the State's interest in these two mines.
We have three additional concerns about the report's analysis
of Finding 11. We believe that the concept that the Trust is to
receive no more or less revenue than it's share of the appraised
value of the ore body using a royalty is flawed. The only way to
ensure that this would happen is to make a cash sale. The net
present value of the ore body is the value of the ore after
recovery costs are deducted. A royalty that captured all of this
value would eliminate the mine's profit and would remove the
incentive for mining.
The Department hired, through the State procurement process, a
professional mineral appraiser to make the appraisals of the ASARCO
and Magma mines. We believe that it is inappropriate for the
Auditor General's report to make statements about what is
ttincorrecttiln the State appraiser's subjective opinion of value
without including the appraiser's response to the questions you
have asked him about what you perceive to be inadequacies in his
report.
We believe that Table I in the report is of no value even
though it is the basis for your conclusion. All it does is
unilaterally accept the consultantts values. Another appraiser
would almost certainly have a different value.
Further, the table is flawed because it attempts to add your
consultant's values generated as a percentage of the total ore body
with the Department appraiser's values generated from the net
present value of the royalty income. It then compares the total
with the appraiser's value. The result has no meaning because the
adjustments are related only to the value of the ore body, not the
value of the royalty income.
Findincf 111: The De~ artment Should Ensure that Future
Adjustments to it's Slidina Scale Rovaltv Formula are A~ pro~ riate.
The Department agrees with Finding 111, however, we disagree
with the recommendation that the Department should not allow
adjustments to the sliding scale formula based on annual production
costs.
Douglas R. Norton
March 5, 1992
Page 4
Some form of adjustment is necessary if a sliding scale is
used with the gross value of copper as the adjuster. The original
equities of the scale will be lost if inflation occurs impacting
either the production cost or copper price or both. The following
illustration is derived from one of the mineral leases.
The royalty calculations beginning with calendar year 1992, the
lower and upper CIP limits described in section 3.3~ as $ 1.10 and
$ 1.60 respectively shall each be adjusted either upward or downward
by an amount equal to the difference between the new five year
average production cost (" NFYAPC"), referring in this initial
adjustment to the five year period 1987- 1991 inclusive, and the
last five year average production cost ( LFYAPC), referring in this
initial adjustment to the five year period 1986- 1990 inclusive.
The formula for calculation of the lower CIP limit, where NLL
equals the new lower limit, PLL equals the previous lower limit ( in
this initial adjustment $ 1.10 cents), shall therefore be:
NLL = PLL + ( NFYAPC - LFYAPC)
As you can see the adjustment factor is an index. The base
number is adjusted in both directions, upward and downward by this
index. The base is not directly adjusted to last year's costs as
suggested by the report. Numerous indices were considered. We
believe the one chosen to be appropriate because it is based on
factors specific to the mine rather than on indices only remotely
related to mine costs.
Findins IV: Improvements Needed for Plannins and Manasement
of the Mineral Lease Prosram.
The Department agrees with Finding IV. To this end, the
Department has prioritized the appraisal effort toward the small
producing mines. The appraisal of non- producing mineral leases is
also in process. Completion of all mineral lease appraisals is
expected by December 31, 1992.
In summary, we believe that the Department has adopted an
innovative sliding scale royalty, based on an index that reflects
gross value copper prices and mining costs, that is fair to both
the Trust and the mineral lessees and that is more advantageous to
the Trust than other royalty schedules we have found in the market
place.
The royalty schedules that the Department has applied to the
Magma and ASARCO mineral leases have captured over $ 12 million in
additional royalties, and total royalties of $ 23,251,021, from
these two mines during the 1988- 1991 period. These schedules will
continue to produce a fair return to the Trust that is
Douglas R. Norton
March 5, 1992
Page 5
substantially greater than would have been received under the old
fixed rate royalty based on net value of minerals produced. We
also expect these royalty schedules to capture much more than the
present appraised value of the State's interest in these two mines.
The report contains suggestions for changes that will improve
the overall quality of the Department's minerals management
program. We will implement these changes.
Thank you for the opportunity to comment on this report.
Sincerely,
M. J. ~ asseli
MJH : dcd

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DOUGLAS R. NORTON, CPA
AUDITOW GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
March 10, 1992
Members of the Arizona Legislature
The Honorable F i f e Symington, Governor
Mr. M. J. Hassell, Commissioner
State Land Department
Transmitted herewith i s a report of the Auditor General, A Performance
Audit of the State land mineral leasing program. This audit was
conducted under the provisions of Session Laws 1989, Chapter 288,
Section 9.
The report evaluates the performance of the State Land Department in
enforcing the 1989 revisions to i t s mineral leasing program and the
impact of those changes. We found that the changes in royalty rates for
mines producing on State land generated an additional $ 12 m i l l i o n in
royalty payments to the State over the past four years, approximately 93
percent more than would have been collected under the old formula.
1,
However, mining economists who reviewed the appraisals for the two copper
mines producing on State land found that the appraisals were d e f i c i e n t .
The deficiencies may have led to incorrect calculation o f the State's
interest in the mines and amount o f royalty payments to the State.
My s t a f f and I w i l l be pleased to discuss or c l a r i f y items in the report.
This report w i l l be released to the public on March 11, 1992.
Sincerely,
DRN : l mn
2700 NORTH CENTRAL AVENUE * SUITE 7 0 0 . PHOENIX, ARIZONA 85004 . ( 602) 255- 4385 ' FAX ( 6 0 2 ) 255- 1251
SUMMARY
The Office of the Auditor General has conducted a review of the State
land mineral leasing program as modified by the provisions of Session
Laws 1989, Chapter 288, Section 9. The session law authorized the review
and s p e c i f i c a l l y directed the Auditor General to evaluate the performance
of the State Land Department in enforcing the provisions of the above
legislation and assess i t s economic impact.
The New Mexico- Arizona Enabling Act granted the State of Arizona more
than 10 m i l l i o n acres of trust lands to support numerous beneficiaries,
most notably public schools. The State Land Department ( under the
direction of a Commissioner appointed by the Governor) was created as a
trustee to administer these lands in a manner that w i l l produce the
largest amount of revenue for i t s beneficiaries. Although the Enabling
Act required that State lands be appraised before lease, State law did
not require an appraisal; lessees of State mineral lands paid only a
fixed royalty of 5 percent of the net value of the minerals produced.
However, in 1989, the U. S. Supreme Court ruled that the Arizona statutes
were invalid. In an e f f o r t to implement the U. S. Supreme Court decision,
the Legislature enacted new mineral leasing statutes in June 1989 that
established a minimum royalty rate of 2 percent based on the gross value
of a l l recovered minerals, and required royalties to be based on the
appraised value of the minerals located on State lands. After the
enactment of the new statute, the Department contracted for the appraisal
of the two largest copper producing mines operating on State lands.
These two mines accounted for approximately 98 percent of the royalties
collected by the Department in fiscal year 1990- 91.
Revisions To Mineral Leasina Statutes
Have Produced Sianif icant Economic Impact
To The State ( see pages 5 through 10)
The 1989 statutory change in royalty rates for mines producing on State
lands generated an additional $ 12 m i l l i o n to the State over the past four
years, approximately 93 percent more revenue than would have been
realized under the old formula. However, the impact of the statutory
change on the mining industry i s less certain. Some in the industry view
the new rate as an added cost that makes exploration or production on
State land less a t t r a c t i v e . However, industry representatives also
indicate that other factors, including mineral prices and environmental
l i a b i l i t y , affect decisions about where to explore or mine.
The De~ artment Should Ensure That Future Appraisals
Correctlv Estimate The State's Interest
In Its Mineral Lands ( see pages 11 through 18)
Under the requirements of A. R. S. $ 27- 234, the Commissioner must appraise
a l l State lands leased for the purpose o f extracting minerals. In the
case of the two largest copper producing mines, only a portion of each
mine i s located on State lands, approximately 44 percent of one and 7
percent of the second. As such, i t was necessary for the Department to
appraise the total value of each mine in order to determine the value of
the State's interest in the mine. To appraise the t o t a l value required
the Department to estimate the value of each mine's ore reserve and
establish the cost of production, including an analysis of capital
investment, capital costs and taxes.
Although Arizona realized significant additional revenues as a result o f
the 1989 revision, the methodological assumptions used by the Department
to determine the State's interest in the two largest mineral producing
mines were incorrect. A review by two mining economists ( hired to assist
us in our evaluation of the appraisals of the two mines) i d e n t i f i e d
several departures from standard appraisal techniques that affect the
value of the State's interest in these two mines. The deficiencies noted
by our consultants included the incorrect calculation of the value of the
ore reserves, unrealistic capital costs, inadequately defined taxes and
subsidies, and the inappropriate deduction of royalty payments.
ti?
These deficiencies in the appraisals have a direct impact on the
valuation of each mine and, therefore, the value of the State's interest
in each mine. While a f u l l reappraisal w i l l be necessary to accurately
determine the value of each mine and the State's interest, our
consultants estimated that the appraisal had understated the amount of
the State's interest in one mine by approximately $ 30.4 m i l l i o n , and
overstated the State's interest in the second mine by an estimated
$ 900,000. Although any estimate of the future impact these valuation
changes w i l l have on royalty collections is hampered by the limitations
of the data used in the original appraisals, we estimate that additional
royalties might have been due from both mines i f the appraisals had been
performed correctly.
Despite the problems i d e n t i f i e d with the appraisals, the Department may
not be able to modify the contracts signed with the mines. The mistakes
in the appraisal process appear to be mistakes which were accepted by the
Department. Changing the contracts with the mines because of these
mistakes would probably require the consent of the mines. Although the
Department can l i k e l y do nothing about the problems with the existing
mineral leases, i t should develop guidelines to ensure that future
appraisals correctly assess the State's interest in i t s mineral lands.
The Department should incorporate these guidelines into a l l future
appraisals.
The Department Should Ensure That Future
Adiustments To Its slid in^ Scale Rovaltv Formula re Appropriate ( see pages 19 through 22)
To determine the amount of royalties each mine should pay for the
extraction of copper ore, the Department has developed a s l i d i n g scale
royalty formula. Although the use of a s l i d i n g scale formula appears
appropriate, future adjustments to the formula should be based on
appropriate data. The Department's leases with the two largest copper
mines c a l l for an annual adjustment of the formula based on changes in
production costs of the mines. However, according to our consultants,
the production cost data used to adjust the formula includes
inappropriate costs i e , interest costs and royalty payments) which
could result in the mines paying less in royalties.
Improvements Needed For P lanninq
And Manaaement Of The Mineral
Leasina Proaram ( see pages 23 through 27)
The Department should improve i t s overall planning and management of the
mineral leasing program. Although the Department exceeded statutory
deadlines in implementing the 1989 revisions to the mineral leasing
statutes for the two largest producing mines, we found much of the delay
appears j u s t i f i e d . However, the Department's f a i l u r e to appraise the
remaining eight producing mines operating on State lands could result in
l o s t interest revenue to the State. As such, the Department can and
should strengthen planning and management for the remaining mineral
leases, p a r t i c u l a r l y the producing leases, and for future leases to l i m i t
delays in conducting appraisals and establishing royalty rates.
TABLE OF CONTENTS
Pane
INTRODUCTION AND BACKGFWND. . . . . . . . . . . . . . . . . . 1
FINDING I: REVISIONS TO MINERAL LEASING
STATUTES HAVE PROWCED S l GN I F l CANT
ECONOMIC IMPACT TO THE STATE . . . . . . . . . . . . . . . 5
Dollar Impact Of Royalty Rate Change . . . . . . . . . . . 5
Impact Of Royalty Rate On Mining Industry. . . . . . . . . 7
FINDING II: THE DEPARTMENT SHOULD ENSURE THAT FUTURE
APPRAISALS CQRRECTLY ESTIMATE THE STATE'S
INTEREST IN ITS MINERAL LANDS. . . . . . . . . . . . . . .
Appraisals Were Not Conducted According
To Standard Appraisal Methodology. . . . . . . . . . . . .
The Department Needs To Provide
Clear Direction For
Future Appraisals. . . . . . . . . . . . . . . . . . . . .
Recommendation . . . . . . . . . . . . . . . . . . . . . .
FINDING Ill: THE DEPARTMENT SHOUU) ENSURE THAT FUTURE
ADJUSTMENTS TO ITS SLIDING SCALE
ROYALTY F W L A ARE APPROPRIATE. . . . . . . . . . . . . .
Use And Appropr i ateness
Of The Sliding Scale Formula . . . . . . . . . . . . . . .
Use Of Appropriate Break- Even
Price In The Sliding Scale Formula . . . . . . . . . . . .
Recommendation . . . . . . . . . . . . . . . . . . . . . .
FINDING IV: IMPROVEMENTS NEEDED FOR PLANNING
AND MANAGEMENT OF THE MINERAL LEASE PROGFW. . . . . . . .
Implementation Impeded For
Two Largest Mines. . . . . . . . . . . . . . . . . . . . .
Improvements Needed For Planning
And Management Of Lease Program. . . . . . . . . . . . . .
Recommendations. . . . . . . . . . . . . . . . . . . . . .
ILLUSTRATIONS
Paae
CHART 1 A Comparison Of Total Income
To The State Under The
Old vs. New Royalty Formula. . . . . . . . . . .
(; RAPH A Copper Prices For The Period
From January 1980 To February 1991 . . . . . . .
TABLE 1 Estimated Value Of The State's Interest
In The Two Largest Copper Mines. . . . . . . . .
TABLE 2 State Land Department Sliding ScaleRoyalty Formula. . . . . . . . . .
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a review of the State
land mineral leasing program as modified by the provisions of Session
Laws 1989, Chapter 288, Section 9. The session law authorized the
review and s p e c i f i c a l l y directed the Auditor General to evaluate the
performance of the State Land Department in enforcing the provisions of
the above l e g i s l a t i o n and assess i t s economic impact.
Histotv And Purpose
Of Trust Lands
In 1910, the New Mexico- Arizona Enabling Act became law, allowing the
people of these t e r r i t o r i e s to form state governments. The act included
provisions that confirmed previous land grants and issued new grants
encompassing almost ten m i l l i o n acres to the State of Arizona. The
conditions attached to the granted lands require that ( 1) granted lands
could not generally be sold or leased except to the highest bidder at a
public auction following notice by advertisements; ( 2) the granted lands
could not be sold or leased for less than the value set by a required
appraisal ; and ( 3) al l proceeds from the lands would be used for the
support of numerous beneficiaries. By r a t i f i c a t i o n of the Arizona
Constitution in 1911, the Arizona electorate accepted the land grants
and conditions. State lands now encompass approximately 9.5 m i l l i o n
acres for the benefit o f numerous educational, health, and correctional
i n s t i t u t i o n s .
Role Of The
State Land Department
The Enabling Act imposed a fiduciary responsibility on Arizona regarding
State lands. In 1915, the Arizona Legislature created the State Land
Department to "... administer a l l laws relating to lands owned by,
belonging to, and under the control of the state.'' Under the direction
of a Commissioner, who i s appointed by the Governor, the Department's
primary function i s to administer Arizona's trust lands in a manner that
w i l l produce the highest revenue y i e l d for the numerous beneficiaries.
Funds from land transactions are deposited into either a permanent fund
or an expendable fund as specified in the Enabling Act. Permanent fund
revenues come from the sale of land or royal t i e s from natural products
of the land. These funds are not expendable for any purpose and are
invested by the State Treasurer in interest- bearing securities.
Expendable fund revenues include lease revenue from land leases and
permits, interest from sales contracts, and interest earned on permanent
fund investments, and are available to beneficiaries to use d i r e c t l y for
their operations.
The Department's Minerals Section, located within the Natural Resources
Division, administers the mineral leasing program. In addition to
mineral leases, the section administers prospecting permits, o i l and gas
leases, as well as mineral material leases and sales. The Minerals
Section i s also responsible for the geologic evaluation of a l l State
land sales and the economic reevaluation of a l l mineral leases.
Royalty Rates Under
Previous Arizona Statutes
Section 28 of the Enabling Act specified that State lands could not be
leased for less than their value as determined by an appraisal. Arizona
passed i t s own statute ( Arizona Revised Statutes $ 27- 234) that required
leases on State mineral lands to pay a royalty of 5 percent of the net
value(') of the minerals produced, but did not requirs those lands to be
appraised before they were leased, or require those lands to be leased
at their f u l l appraised value.
In 1980, the O f f i c e o f the Auditor General released a report on the
State Land Department ( Performance Audit Report No. 80- 3). The report
recommended adoption of a gross value royalty, as opposed to net, to
increase State royalty revenue and el iminate the accountabi l i t y problems
associated with a net royalty system.
( 1) Net value i s defined as gross value a f t e r processing, less the cost of transportation
from place of production to place of processing, the costs of processing, and taxes
on product; on.
Court Proceedinss
In 1981, a s u i t against the Department was f i l e d in the Maricopa County
Superior Court by individual taxpayers ( Kadish) and an association of
public school teachers ( represented by the Center for Law i n the Public
interest). The s u i t sought to invalidate Arizona's fixed 5 percent
royalty rate. The p l a i n t i f f s contended that the State statute
impermissibly resulted in the extraction o f minerals without payment of
the f u l l value to the State. The p l a i n t i f f s claimed that such a
l i m i t a t i o n o f income was contrary to the requirements of the Enabling Act
and the Arizona Constitution. In 1985, the Superior Court ruled in favor
of the Department.
Subsequently in 1987, on appeal by the p l a i n t i f f s , the Supreme Court of
Arizona reversed the lower Court decision, declaring the State statute
unconstitutional and void. Several mineral lessees then petitioned the
U. S. Supreme Court to review the Arizona Supreme Court decision. The
U. S. Supreme Court concluded, in a 1989 ruling, that lease of mineral
lands granted to the State of Arizona under the Federal statutes must
substantial ly conform to the mandatory requi rements of the Enabl ing Act,
and the Arizona Supreme Court was correct in declaring the Arizona
statutes invalid.
1989 Mineral Leasing Statute
@
In an e f f o r t to implement the U. S. Supreme Court decision, the
Legislature repealed A. R. S. 327- 234 and enacted new mineral leasing
statutes in June 1989 ( Session Laws 1989, Chapter 288). The new statutes
require an annual land rental as well as a royalty fee o f a t least 2
percent based on the gross value of a l l recovered minerals. The royalty
rate for each mineral lease must be the appraised value of the State's
interest in each mine, and expressed as a percentage of the gross value.
In September 1989, the Department began to develop procedures for
implementing the new law and contracted for the appraisal of the two
largest copper mines operating on State lands. However, because only a
portion of each of the two copper mines i s located on State lands
( approximately 44 percent of one and 7 percent of the second), i t was
necessary for the Department to appraise the t o t a l value of each mine in
order to determine the value of the State's share or interest in the
mine. These two mines accounted for approximately 98 percent of the
royalties collected by the Department in fiscal year 1990- 91.
Audit Scope And Methodolow
The scope of our audit i s defined by Session Laws 1989, Chapter 288,
Section 9:
The auditor general shall review the status of mineral leasing on
s t a t e t r u s t lands. The review and report shall include: 1) the
performance of the state land department in enforcing the
provisions of t h i s act, 2) the economic impact of t h i s act.
To accomplish t h i s directive, our audit contains findings in the
following areas:
the economic impact of the 1989 revisions to the mineral leasing
statutes;
the techniques used to appraise the State's share of two copper mines;
the Department's use of a s l i d i n g scale formula to collect royalties
from mineral leases; and
planning and management of the mineral lease program.
To further assist us in our review of the appraisals of the two largest
copper mines and the s l i d i n g scale royalty formula, we retained the
mining economics consulting f i r m o f Newcomb and Harris. Drs. Newcomb and
Harris have over 24 years' experience in mineral appraisal, materials
markets, and the evaluation of mineral resources and reserves. The
consultants' assessments and recommendations are presented throughout
Findings II and I l l .
This audit was conducted in accordance with government auditing
standards.
The Auditor General and s t a f f express appreciation to the Commissioner
and s t a f f of the State Land Department for t h e i r cooperation and
assistance during our audit.
FINDING I
REVISIONS TO MINERAL LEASING STATUTES HAVE
PRODUCED SIGNIFICANT ECONOMIC IMPACT TO THE STATE
The 1989 statutory change in royalty rates to mines producing on State
land has generated an additional $ 12 m i l l i o n to the State. Over the past
four years, the new royalty formula has generated approximately 93
percent more revenue than would have been realized under the old
formula. However, the impact on the mining industry i s less certain.
Some in the industry view the new rate as an added cost that makes
exploration or production on State land less a t t r a c t i v e . Industry
representatives also indicate that other factors affect decisions about
where to explore or mine.
Dollar lrn~ act Of
Rovaltv Rate Chanse
The new royalty rate has greatly impacted c o l l e c t i o n o f revenues from the
two major copper producers on State land. Although only two mines have
been charged the new rate, payments to the State over the past four years
have nearly doubled. Because the p r i c e o f copper is now considered in
the royalty formula, much of this increase i s due to higher than average
copper prices in recent years.
Revenue contribution of two copper producers - While the 1989 statutory
revisions and the resulting royalty rate change affect a l l mineral leases
on State lands, two copper mines, the Asarco Mission Mine and the Magma
San Manuel Mine generate most of the royalty revenue. For example, in
fiscal year 1990- 91, Asarco contributed approximately 72 percent and
Magma more than 25 percent to the total royalties collected by the
Department.
Increase i n royal tv income - Asarco's and Magma's royalty payments have
increased almost 93 percent over the past four years as a result of the
new royalty rate. Chart I ( page 6) shows that from 1988 through 1991
royalties collected from these companies were s i g n i f i c a n t l y higher than
they would have been under the old formula. For example, in fiscal year
1988- 89, under the old royalty rate the two mines generated revenues of
$ 4.7 m i l l i o n ; under the new royalty rate, they generated revenues of $ 9.8
m i l l i o n , an increase of 106 percent. In t o t a l , over the past four years,
the State has collected additional revenue of approximately $ 12 m i l l i o n
from the two mines under the new royalty rate.
Role of comer orices - Because the new s l i d i n g scale formula takes
copper prices into account in determining the mines' royalty rate, when
copper prices increase, royalties increase. As Graph A ( page 8)
indicates, copper prices have fluctuated s i g n i f i c a n t l y in the past ten
years, ranging from a low of 61 cents per pound in August 1986 to a high
of $ 1.60 per pound in December 1988. Additionally, the p r i c e o f copper
per pound f e l I below $ 1 from August 1980 to October 1987. However,
because prices have been higher over the past four years, the two mines'
royalty payments have exceeded the minimum 2 percent of gross established
by statute. Asarco contributed an average of 5.65 percent of gross from
December 1987 through December 1990, wh i l e Magma con t r i bu ted an average
of 3.7 percent of gross from December 1987 through Apri l 1991.
Conversely, had copper prices been lower during that period, royalty
payments from both mines would have been closer to the statutory minimum.
Impact Of Rovaltv Rate
On Minina lndustw
The mining industry representatives we interviewed perceive the new
royalty rate as an increase in the cost of mining on State lands.
Therefore, they are reluctant to invest in sites on State lands because
they fear their p r o f i t s w i l l be eroded by the new rate. Delays by the
Department have made assessing the impact of the rate increase
d i f f i c u l t . Although factors such as mineral prices and environmental
l i a b i l i t y also contribute to the cost of mining, the mines are focusing
on the impact of the new rate.
Perce~ tionso f the m i n i n ~ in dustry - Companies mining on State lands are
unhappy with the new royalty formula and say i t has increased the cost of
their operations on State lands. One industry spokesman called the
new rate the " ki l l ing of the golden goose." The new 2 percent of gross
method i s perceived as an " unknown" by industry re, resen tat i ves because
the unpredictable future price of copper plays such an important role in
the new royalty formula. However, according to a Department o f f i c i a l ,
the new royalty rate, once established, i s very precise, whereas the old
rate could be more easily manipulated by the mines.
According to several mining o f f i c i a l s , the result of the new royalty rate
may be a decrease in prospecting and exploration on State lands. These
o f f i c i a l s contend that, given a choice, a company would choose to mine on
private or Federal lands rather than State lands because royalty rates on
private lands are established prior to exploration and, therefore, are
set before mining occurs. Consequently, the price o f copper has no
impact on the rates paid. Further, because mining on Federal lands does
not require the payment of royalties, mining there costs less.
Finally, we spoke with four companies with production capabilities on
State lands. Each company considers the new royalty rate an important
factor in i t s decision to develop on. these lands. While factors such as
mineral prices also play a role, one company o f f i c i a l said that in their
market analysis they need to know that the mineral potential on State
lands i s enough t o o f f s e t the higher royalty rate.
Delavs bv the De~ artment - The mining industry's concerns about the new
royalty rates have been affected by the Department's f a i l u r e to complete
timely appraisals of a l l mines operating on State lands. As explained in
Finding IV ( page 23)) because of delays in mine appraisals by the
Department, the impact of the new royalty rate i s d i f f i c u l t to measure.
Until more mines have been appraised, the total impact of the new royalty
rate on a l l the mines affected cannot be determined.
Other considerations i n decidinq where and when to mine - While the
royalty rate influences the mines1 decision to develop State lands, other
factors also have an impact. Mineral prices, environmental protection,
l i a b i l i t y cosiderations, and the general state of the economy a l l
contribute to the potential prospecting and development equation. Mining
industry o f f i c i a l s c i t e the price of copper and other minerals as factors
that are as important as the royalty rate in determining whether to
initiate development of mines on State lands. Further, according to a
Department official, stricter environmental controls increase mining
costs significantly. Because mines are financially liable for cleaning
up all environmental damage caused by their activities, clean- up costs
can substantially affect the potential profitabi l i ty of a mine. Final ly,
mining industry officials mentioned several other important factors they
consider before deciding to mine a particular mineral deposit. These
factors include the general state of the economy, labor and facility
operations costs, the demand for the mineral, the qua\ ity of the deposit,
and the ease of extraction.
FINDING II
THE DEPARTMENT SHOULD ENSURE THAT FUTURE APPRAISALS
CORRECTLY ESTIMATE THE STATE'S INTEREST
IN ITS MINERAL LANDS
Although Arizona has realized significant additional revenue as a result
of the 1989 mineral leasing revisions, the methodological assumptions
used to appraise the State's interest in mines operating on State lands
were incorrect. Our review revealed several departures from standard
appraisal techniques that s p e c i f i c a l l y a f f e c t the value of the State's
interest. The Department should develop guidelines to ensure that
assumptions made in future mineral appraisals do not incorrectly reduce
royalty payments to the State.
Appraisals Were Not Conducted Accordinq
To Standard Ap~ raisal Methodolocry
Appraisals of the two largest copper mines operating on State lands did
not include the use of several standard appraisal techniques. According
to A. R. S. $ 27- 234, the Commissioner i s required to conduct appraisals
according to standard appraisal methodology to establish the value of the
State's interest in a l l minerals recovered on State lands. With the aid
of consultants, we identified several deficiencies in appraising the
State's interest. These deficiencies impact the value of the State's
interest and the amount of royalty collected by the Department.
Appraisal reauirements - Under the new mineral leasing statutes enacted
in 1989 ( A. R. S. $ 27- 234), the Commissioner must appraise a l l State lands
leased for the purpose of extracting minerals. The appraisal i s intended
to establish the value of the minerals contained on these lands, and i s
then used to determine a royalty rate that w i l l obtain the f a i r value of
the minerals from the mining companies leasing the lands.
Ap~ raisal of two mines - Although numerous mineral leases have been
issued by the Department, the majority of the mineral royalty revenue
collected by the Department is derived from only two leases.(') These
( 1) These two leases accounted f o r approximately 98 percent of the royal t i e s collected by
the Department i n f i s c a l year 1990- 91.
two leases include State lands that represent a portion of two large
copper mines, the Asarco Mission Mine and the Magma San Manuel ~ i n e . ( l )
The Department contracted with a mining engineer to appraise the value of
the minerals contained on the State lands leased by these two mines. In
conducting the appraisals, the Department's appraiser determined that
since only a portion of each of the two mines i s located on State lands,
i t was necessary to appraise the total value of each mine in order to
establish the value of the minerals located on the State lands leased to
the mines. In doing so, the appraiser established both a total value of
each mine as well as the value of the State's interest in each mine
( i . e., value of the minerals contained on the State lands when included
as a portion of the total value of the mine.) To determine the total
value of the mines, the Department's appraiser established the present
value of each mine's expected cash flows ( or income minus costs) over the
expected l i f e of the mine. To accomplish this, the appraiser estimated
the value of each mine's ore reserve and established the cost of
production, which included analysis o f capital investment, capital costs
and taxes. The State's interest in each mine was determined by
estimating the value of the royalties the Department could collect from
the minerals contained on State lands, using a fixed royalty rate o f 5
percent of the net value of the minerals.
Appraisal deficiencies - Several deficiences l i m i t the accuracy of the
appraisals conducted on the two largest copper mines operating on State
lands. We found the appraisal methods u t i l i z e d by the Department's
appraiser were i n s u f f i c i e n t to accurately determine the State's
interest. Several deficiencies were noted by our consultants, including
the f o l lowing:
Ore Reserves Incorrectly Calculated - The Department ' s appraiser
incorrectly estimated the value of the ore reserves by ( 1) using a
constant copper price with a fixed estimate of the size of the ore
reserve, and ( 2) using constant production costs based solely on a
one- year period. However, the value of the metals in the ore
reserves does change with price and cost, both of which vary widely
( 1) The Asarco Mission Mine i s an open p i t mining operation, approximately 44 percent of
which i s located on State lands. The Magma San Manuel Mine i s an underground mining
operation, of which approximately 7 percent i s located on State lands.
from year to year. In addition, it i s unlikely that cost would
remain constant i f production were to increase. Furthermore, a
one- year period does not provide s u f f i c i e n t history for evaluating
the changes in price and cost. Since the value of the ore body i s
based on the results of simulations using a range of values, the
assumption of constant prices and costs for such a limited period
does not provide an accurate basis for valuing the ore body. Our
consultants recommend that the Department review mine information
( prices and cash flows, tonnages, outputs) periodically so deviations
from appraisal estimates can be made an integral part of analysis,
thereby increasing the accuracy and consistency in calculating the
State's interest and mine value.
State's Interest lncorrectlv Calculated - The Department ' s apprai ser
failed to adequately determine the value of the State's interest.
The appraiser established the State's interest in each mine by
estimating the value of the royalties the Department could collect
from the minerals contained on State lands, using a fixed royalty
rate of 5 percent of the net value of the minerals. Our consultants
recommend valuing the State's interest as a net present value after
the mines' costs, excluding royalties, are deducted.
Validity of Price- Cost Estimates Uncertain - The Department ' s
appraiser did not s t a t i s t i c a l l y test the appropriateness of either
his pricing forecasts or cost estimates, nor did the appraisal
contain the information necessary to conduct these tests. Since
price and cost estimates are judgmental in forecasting, tests f o r
consistency or significance must be performed. Our consultants
recommend ( 1) including tests o f p r i c e significance, such as a short
run, five- year moving average, forecast model in appraisals, and ( 2)
modifying the costing approach to e x p l i c i t l y identify key costs and
l i n k them to database simulations.
Misstatement of Caoital Investment - Cap i ta l investment was misstated
in three s i g n i f i c a n t ways. F i r s t , i n i t i a l capital less depreciation
was not included i n calculating the t o t a l investment i n either mine.
Second, in valuing the Magma mine, the appraisal included the cost of
refurbishing processing f a c i l i t i e s that do not s o l e l y pertain to the
State's interest. Third, the appraisals did not completely report or
document net investment, depreciation, and depletion charges used in
cash flow analysis. Without this e x p l i c i t information, the appraisal
cannot accurately determine the net value of the mines.
Cost of Capital Unrealisticallv Hiqh - The cost of capi t a l used in the
appraisal i s not related to the industry and the mines' financial
experiences. The appraisal used a subjective discount rate(') of 17
percent for both mines, which included a 7 percent p r o f i t margin.
According to our consultants, i t i s very unlikely that
( 1) The discount rate i s defined as the i n t e r e s t rate used to calculate the present value
of a specific pattern of cash flows less the rate of i n f l a t i o n . At a minimum, without
uncertainty or risk of default, the rate should be set a t the risk- free i n t e r e s t r a t e
less the expected rate of i n f l a t i o n .
the mines could sustain a real 17 percent cost of capital over a
ten- year period as assumed by the appraisal. Our consultants estimate
that the real discount rate i s closer to 13.4 percent for Asarco and
14.4 for Magma.
8 Taxes and Subsidies Inadequately Defined - The appraisal used
effective tax rates(') rather than code tax rates. The effective tax
rate i s unrealistic because i t disguises information important to the
lessor about revenue, royalty, and depletion. The effective tax
rate, unlike the code tax rate, can vary annually, which makes i t
unauditable. To correct these deficiencies, our consultants
recommend that tax options and deductions be incorporated into the
cash flows by the use of an accounting program s p e c i f i c a l l y developed
for mining operations.
8 Inappropriate Deduction of Royalty Payments - The in i t i a l apprai sa l s
inappropriately deducted royalty payments from the cash flows in
determining the value of the mines. The purpose of the appraisal i s
to determine an appraised basis against which royalties w i l l be
assessed. Therefore, deducting royalty payments as a cost
incorrectly reduces the value of the State's interest in the ore body.
Im~ act on mine value, State interest. and cost of production - The
appraisal deficiencies noted above d i r e c t l y impact mine valuation, the
State's interest, and the mine's cost of production. Our consultants
attempted to measure the total impact of these appraisal deficiencies.
However, their e f f o r t s were limited to using the same information used by
the Department's appraiser. To accurately determine the mine's value and
the State's interest, a f u l l reappraisal must be performed.
In estimating the impact of the appraisal deficiencies for each mine, our
consultants broke down costs shown in the appraisal and simulated cash
flows under a correct model. Correction of the deficiencies i s made
progressively in three steps. As shown in Table 1 ( page 15), the
individual impact at each stage is estimated as well as the combined
impact of the deficiencies on the value of the State's interest.
( 1) The e f f e c t i v e tax rate i s a weighted average that sununarizes the net e f f e c t of various
taxes and deductions so that i t i s an aggregate of those individual changes.
TABLE 1
Estimated Value Of The State's
Interest In The Two Largest Copper Mines
Department Appraised Value
Effect Of Appraisal Corrections
on Appraised Value
Step 1: Incorporating estimates of
the i n i t i a l capital, defining
taxes, and subsidies, and
correcting the calculation o f
the State's interest.
Step 2: Adjusting the cost of capital
from 17 percent to 13.32 percent
and 14.40 percent, respectively.
Step 3: Restoring the deduction of
royalty from revenues.
Estimated Appraised Value
After Correction of
Appraisal Deficiencies
TOTAL DIFFERENCE
Source:
Asa r co h g m
( millions) ( millions)
$ 20.0 $ 3.0
Office of the Auditor General, s t a f f analysis of data
obtained from our consultants' report.
As shown in Table 1, for Asarco, adjustments increase the corrected
State's interest to $ 50.4 m i l l ion, $ 30.4 mi l l ion ( or approximately 150
percent) more than the Department's appraised value. For Magma,
adjustments reduce the corrected State's interest to $ 2.1 mi l lion, $. 9
mi I l ion ( or 30 percent) less than the Departments appraised value.
These changes also affect the mines' cost of production. The net effect
on Asarco's cost of production i s an increase of one cent above the
Department's value. The net effect on Magma's cost of production i s a
significant reduction of approximately 26 cents.
Im~ act on royalty receipts - The appraisal deficiencies can impact the
amount of royalty collected by the State. While the net effect on
current royalty payments cannot be determined accurately without a f u l l
reappraisal, changes in the appraisal values clearly have the potential
to impact royalty receipts. The change in the appraised value at Asarco
w i l l impact the amount of royalty to be collected. As the royalty
formula was developed to collect the State's appraised value, an
estimated increase in the State's value at Asarco would mean additional
royalty w i l l have to be collected to ensure the State's interest i s
recovered. Furthermore, due to the decrease in Magma's cost of
production, a c r i t i c a l element in the new royalty formula, the State
could potential ly col lect more royalty under the new formula than i t did
under the old formula despite the reduction in the value of the State's
interest.
The Department Needs
To Provide Clear Direction
For Future Appraisals
The Department needs to more clearly define assumptions used in
appraisals of State mineral lands. Although the Department may lack the
a b i l i t y to r e c t i f y the deficiencies of the appraisals on the Asarco and
Magma mines, i t can establish guidelines to be used in future appraisals.
Masma and Asarco a ~ ~ r a i s a sl sta nd - Despite the problems identified with
the Magma and Asarco appraisals, the Department probably cannot modify
the contracts signed with the mines. The lease i s a separate document
from the appraisal and i s a contract between the State and the mines.
According to our General Counsel and the Assistant Attorney General who
represents the Department, the Department appears to have no legal basis
for changing the contract even though the assumptions used by i t s
appraiser do not conform to the statutory requirement for standard
appraisal methodologies.
The Department's actions in accepting the contract l i m i t i t s a b i l i t y to
modify i t after the fact. Department s t a f f raised questions about some
of the appraiser's assumptions during their review. However, these
questions were dismissed and the Department used the appraisal as the
basis for contract negotiations with the mines. Thus, any mistakes i n
the appraisal process appear to have been accepted by the Department and
do not appear to provide the basis for changing the contracts. Under
these circumstances, any change in the contracts would probably require
the consent of the mines.
Guidelines for future a ~ p r a i s a l s - Although the Department may not be
able to address the problems with the existing mineral leases, i t can
develop guidelines to ensure that future appraisals correctly assess the
State's interest in i t s mineral lands. Guidelines are needed to further
define areas of standard appraisal methodologies that are open to
interpretation.
A. R. S. 927- 234 requires the Department to appraise mineral lands using
standard methodology. The Department used a standard methodology, the
income approach, in appraising the State's interest in the Asarco and
Magma mines. However, i t did not direct i t s appraiser in making
assumptions in areas that are not clearly defined by standard appraisal
methodology. As a result, the appraiser used assumptions that
incorrectly reduced the State's interest by approximately $ 30 mi l I ion in
the Asarco mine and overstated i t s interest by an estimated $ 900,000 in
the Magma mine ( see pages 14 through 16).
To avoid future appraisal deficiencies, the Department should c l a r i f y how
appraisers should use assumptions in appraising State mineral leases.
The Department should identify ambiguous areas within standard appraisal
methodologies, evaluate their potential impact on the State's interest in
i t s mineral lands and specify how uncertainties should be resolved to
ensure that appraisals correctly identify the State's interest. The
Department should incorporate these guidelines into a l l future appraisal
contracts.
RECOMMENDATION
The Department should develop procedures to ( 1) ensure that standard
appraisal techniques are applied to enhance the accuracy of the State's
interest and mines' cost of production calculation and ( 2) provide clear
guidance to appraisers in using assumptions in appraising State mineral
lands .
FINDING Ill
THE DEPARTMENT SHOULD ENSURE THAT FUTURE ADJUSTMENTS
TO ITS SLIDING SCALE ROYALTY FORMULA
ARE APPROPRIATE
The Department's use of a s l i d i n g scale formula to establish royalty
rates for State mineral leases appears appropriate; however, an
appropriate break- even price should be used in the formula in a l l future
lease agreements.
Use And Appropriateness
Of The Slidinu Scale Formula
The Department developed a s l i d i n g scale formula to determine royalties
for the two largest copper mines operating on State land. This method
appears appropriate for establishing royalties due the State.
Develoment of the s l i d i n q scale formula - To determine the amount of
royalties each mine should pay for the extraction of copper ore, the
Department has developed a s l i d i n g scale royalty formula. The Department
concluded that h i s t o r i c a l l y copper prices have ranged from well below the
average cost of domestic production to highs that y i e l d net p r o f i t s over
100 percent for e f f i c i e n t producers. Because of the uncertainty
established by the fluctuating p r i c e o f copper, the Department decided
that establishing a s l i d i n g scale royalty formula would be more equitable
to the State and the mines than a fixed royalty rate.
In practice, the s l i d i n g scale formula provides the minimum statutory
royalty of 2 percent of gross when copper prices result i n revenues that
are at or below the mines' production cost, defined by the Department as
the " net present value break- even price". The maximum royalty,
established by the Department at 8 percent of gross, i s the cap of the
s l i d i n g scale and i s applied when copper prices reach or exceed the
highest price experienced in the preceding 178 months. When copper
prices are between the break- even price and the highest price, the
royalty percentage rate i s calculated by using the following formula:
Royalty rate = [( Copper index price - break- even price) x mu1 ti pl i e r l + minimum royal t y
For example, with a break- even p r i c e o f $ 0.80 per pound and a high price
of $ 1.50 per pound, the formula would produce the royalty rates shown in
Table 2.
TABLE 2
STATE LAND DEPARTMENT
Sliding Scale Royalty Formula
Royalty rate = [( Copper index price - .80) x . 0 8 5 7 ( ~ ) 1 + .02
Cooper Index Price Rovalty Rate
( a) The m u l t i p l i e r i s the factor necessary to determine the royalty rate when copper
prices are between the break- even price and the highest price, and i s calculated as
follows:
Maximum royalty rate - Minimum royaltv rate 8% - 2% .0600
-. - -- -- - =. 0857
Highest price - Break- even price 1.50 - .80 .700
Source: O f f i c e o f theAuditor General, s t a f f a n a l y s i s o f d a t a o b t a i n e d
from the State Land Department.
The calculated royalty rate is then applied each month to the gross value
of the mineral concentrates the mine produces from the State lands to
determine the monthly royalty due.
Sl idina scale appears appropriate - According to our consultants, the
Department's use of a s l i d i n g scale royalty appears to be an appropriate
method of determining royalties. Other possible methods of determining
royalties, s p e c i f i c a l l y those that might appear similar to a fixed
severance tax, have been c r i t i c i z e d for d i s t o r t i n g the efficiency of
private industry decisions about the amount of time to mine or how much
to mine and invest in a g iven depos i t . This i s because severance taxes,
and the costs they create, affect the mine's level of production.
Conversely, taxation based on a producer's net income i s preferred by
both economists and the mining industry because i t does not so d i r e c t l y
influence production levels and, therefore, has l i t t l e or no impact on
the mines efficiency and the time necessary to exhaust the deposit. As
such, the Department's royalty rate formula, as a low minimum severance
plus a progressive royalty levied on net income, i s closer to an income
tax and preferable to other methods that approximate a severance tax.
Use Of Appropriate Break- Even
Price In The Slidinq Scale Formula
Although the s l i d i n g scale formula appears to be an appropriate method of
determining royalties, future adjustments to the formula must be based on
the appropriate break- even price. The Department's leases with the two
largest copper mines c a l l s for an annual modification of the formula.
However, the data used for the modifications is inappropriate and can
result in a reduction in royalties to the State.
Lease aareements - The current leases negotiated between the Department
and the two largest copper mines include provisions that allow for annual
adjustments of the s l i d i n g scale formula based on changes i n production
costs of the mines. This production cost data i s derived from the mining
companies' annual tax reports to the Arizona Department of Revenue.
Inappropriate adiustment of the formula - According to our consultants,
the use of annual production cost data computed by the mining companies
cannot be substituted for the net present value break- even price
determined by the appraisal. As discussed in Finding II ( pages 12
through 14), certain costs ( i . e., interest costs and royalty payments)
should be excluded when appraising the net present value of the mines.
Production cost data derived from annual tax reports to the Arizona
Department of Revenue w i l l include the types of costs that should be
excluded from the appraisal. By using t h i s data annually to adjust the
mines break- even price, the Department w i l l be including costs that are
not representative of the mining companies' investment in the mine.
Annual adjustments to the s l i d i n g scale royalty formula based on
production cost data could reduce the State's collection o f r o y a l t i e s .
Because the accounting methods often include capital charges not d i r e c t l y
associated with the mines' a c t i v i t i e s , a break- even price based on these
costs could be s i g n i f i c a n t l y higher than a break- even price derived from
the net present value appraisal. Therefore, since the s l i d i n g scale
formula ( see page 20) uses the mines' net present value break- even price
to determine the minimum royalty payment, any increase of t h i s price
would tend to result in the mines paying less in royalties.
Although the use of inappropriate cost adjustment data may reduce the
State's r o y a l t y c o l l e c t i o n s , the Department does not appear to have any
option to modify the leases with the two mines. As noted i n Finding I
( see pages 15 through 16), the Department i s bound by the lease
agreements signed by the mines and has no basis to u n i l a t e r a l l y change
the terms of those leases. Therefore, any action to ensure that only
correct data i s used in annual adjustments to the s l i d i n g scale must be
limited to future lease agreements.
In any future mineral lease agreements, the Department should not allow
adjustments to the s l i d i n g scale formula based on annual production costs.
FINDING IV
IMPROVEMENTS NEEDED FOR PLANNING AND MANAGEMENT
OF THE MINERAL LEASE PROGRAM
The Department should improve i t s overall planning and management of the
mineral lease program. Although the Department exceeded statutory
deadlines in implementing the 1989 revisions to the mineral leasing
statutes for the two largest producing mines, much of the delay appears
j u s t i f i e d . However, the Department can and should improve i t s
performance in implementing the statutes for the remaining leases.
lrn~ lernentation lrn~ eded For
Two Larqest Mines
For the two largest copper mines operating on State lands, the Department
has taken longer than had been allowed by statute to implement the new
mandated royalty rate. While the statutory deadline for compliance may
have been u n r e a l i s t i c a l l y short, other factors impeded completion of the
lease appraisals and revision o f the royalty rate.
Statutory deadline too short - The new legislation allowed the Department
180 days after June 8, 1989, to appraise mines and set royalty rates.
However, to ensure that t h i s legislation was adequate, the Department had
to wait for a ruling by the Maricopa County Superior Court. On
October 10, 1989, the Court ruled that the provisions of the new
l e g i s l a t i o n corrected the defects in the old statute and conformed to the
U. S. Supreme Court decision, and that leases then in effect were valid.
Thus, following the court ruling, the Department had approximately 80
days remaining in which to comply with the mandated changes. It would
appear that t h i s delay in beginning the appraisal process was beyond the
Department's control and that the statutory deadline may have been
u n r e a l i s t i c .
Other factors hamper implementation - The time required to retain an
appraiser, appraise the mines, and develop a new royalty rate formula
slowed the Department's implementation of the new mineral lease law. For
the two largest copper mines, instead o: six months, i t took
approximately twenty months.
The Department's decision to contract for the appraisal of the two
largest producing copper mines also caused delays. While the Department
reports i t began working on requests for proposals for the appraisals the
day a f t e r the Superior Court ruling, the procurement process through the
State's Purchasing Office took approximately three months to complete.
Our review of the procurement process did not uncover any specific delays
that appeared unreasonable.
In addition, the requests for proposals to conduct appraisals for the two
largest copper mines indicated the contractor would have 120 days to
complete the appraisals. While the i n i t i a l appraisal reports were
completed within the contract time frame, revisions were made after
discussions among the appraiser, the ? epartment and the mines. These
* evisions took an additional three months to complete. Therefore, i t
took approximately seven months from the time the contract was awarded
u n t i l revisions were completed.
The development of an innovative s l i d i n g scale formula for calculating
the new r o y a l t y r a t e required additional time. The Department's new
s l i d i n g scale formula uses the mines' break- even price as a variable on
the s l i d i n g scale. We conducted a survey of eight other states and found
that none had developed a method similar to Arizona's. We also reviewed
industry l i t e r a t u r e and found no comparable formula had been established
that the Department could have u t i l i z e d .
Once the formula was developed, i t s specific parameters were discussed
with and accepted by the two mines. To complete the t o t a l negotiation
process ( i . e . , from appraisal completion to agreement on the formula as
well as other lease terms) took three months for one mine and nine months
for the other.
lm~ rovements Needed For Planning
And Manaaement Of Lease Prosram
The Department should strengthen i t s planning and management procedures
for the remaining mineral leases and for a l l future leases to l i m i t
delays in the appraisal of mines and establishment o f royalty rates. A t
the present time, although there are a substantial number of mines that,
under the law, must also be appraised, the Department has not established
a plan or procedures for addressing these appraisals. Delays in the
implementation of the new royalty rate could result in the loss of
interest to the State in the future.
Additional a ~ ~ r a i s a linsc om~ letea nd untimely - In addition to appraisals
of the two largest producing copper mines, appraisals are required for
nine other producing and eighty- nine nonproducing mines. Because of the
anticipated cost to the mines to contract for these appraisals('), the
Department decided to conduct these appraisals using i t s own s t a f f .
However, the Department has not completed these appraisals in a timely
manne r .
To date, of the remaining nine producing mines, the Department has
completed the appraisal of only one. The other eight producing mines
have s t i l l not been appraised more than two years after the statutory
deadline, although they accounted for nearly $ 91,000 of the royalties
collected by the Department in fiscal year 1990- 91. ( According to the
Department, some appraisal work has been completed on three of these
eight mines.) The Department has also i d e n t i f i e d four nonproducing mines
that could begin production in the near future. Although appraisals have
not been completed on any of these mines, work has begun on only two of
them.
The Department has also not completed appraisals on most of the
nonproducing mines. To date, appraisals of only fourteen of the
eighty- nine nonproducing mines have been completed. The Department's
( 1) A. R. S. 527- 234. E provides that the costs of the appraisals should be charged t o the
mines .
goal i s to complete a l l remaining appraisals by the end of 1992. The
impact of such a s i g n i f i c a n t change i n p r i o r i t i e s on the Department's
other workload i s unclear.
Areas for improved ~ l a n n i nan~ d manaaement - There are several areas in
which improvements in planning and management could f a c i l i t a t e the
completion of the remaining mine appraisals. P r i o r i t i e s must be
established to ensure the timely completion of the appraisals of
producing mines. In addition, the Department's procedures for
implementing the program should be improved.
The Department has f a i l e d t o appropriately p r i o r i t i z e the completion of
the unappraised mines. For example, i n i t i a l l y two employees were
assigned to complete the mineral abstracts for the appraisals of
nonproducing mines while only one employee was assigned to complete the
abstracts for the producing mines. However, only producing mines
generate royalties. Further, because of the time the one employee needed
to devote to the two largest producing copper mines, only one of the
remaining nine producing mines has been appraised, while fourteen of the
nonproducing mines have been appraised.
The Department also needs to review the adequacy of i t s appraisal fees
for appraisals conducted by s t a f f . The statute specifies that the cost
for appraisals should be assessed to the mine owners. The Department
o r i g i n a l l y estimated that a charge of $ 250 per appraisal would be
adequate. This charge i s based on 20 hours of s t a f f time to complete the
appraisal. However, the Department does not monitor the amount of time
required to complete an appraisal to determine whether t h i s charge is
adequate .
Interest could be lost - Delays in the implementation of the new royalty
rate could result in lost interest to the State. Because the Department
has not appraised the remaining eight producing mines, the new royalty
rate has not been applied to the minerals recovered from these State
lands. Although the Department can collect any additional royalties,
based on the new royalty rate, retroactively to December 1987 for leases
then in effect, the State cannot earn interest for the beneficiaries
until the royalties are collected. Further, there are no provisions in
the statute for the Department to collect back interest from the mines.
RECOMMENDATIONS
1. The Department should expedite the completion of appraisals for
producing mines to minimize interest lost to the State either by
placing a higher priority on staff time or contracting appraisals.
2. The Department should develop a procedure to review on an annual
basis the adequacy of charges for staff appraisals.
Arizona
FIFE SYMINGTON
* GOVEFlNOR
1616 WEST ADAMS
PHOENIX, ARIZONA 85007
M. J. HASSELL
STATE LAND COMMISSIONE9
March 5, 1992
Douglas R. Norton
Auditor General
Office of the Auditor General
2700 North Central Avenue, Ste. 700
Phoenix, Arizona 85004
Dear Mr. Norton:
The following comments are offered concerning the Auditor
General's report on the state ~ ineral Leasing Program.
Findins I: Revisions to Mineral Leasins Statutes that
Produced Sisnificant ~ conomic Impact to the State.
The Department agrees with Finding I of the report which
describes the impacts of the $ 12 million increase in revenue in a
four year period to the Trust and the potential disincentive to the
industry accruing from the statutory change.
We were somewhat disappointed that the report did not make a
more comprehensive review of all of the 1989 changes in the mineral
leasing statute. We believe that several of these changes,
including the discretionary right to deny prospecting permits, the
right to auction unleased mines and mineral properties, index
pricing of gross mineral content, and the right to reappraise if
new minerals are discovered or mine technology changes, will have
major long term impacts on the program, and are significant
components of the new mineral leasing statute that were not covered
in the report.
Findins 11: The Department Should Ensure that Future
Appraisals Correctlv Estimate the State's Interest in it's Mineral
Lands.
The Department agrees with Finding I1 of the report and with
the recommendation of Finding I1 which calls for the Department to
develop procedures to ensure that standard appraisal techniques
Douglas R. Norton
March 5, 1992
Page 2
are used to enhance the accuracy of the State's interest and mines8
cost of production calculations, and to provide clear guidance to
appraisers in using assumptions in appraising state mineral lands.
There is apparently a fundamental disagreement between the State
Land Department and the Auditor General about what should be
appraised. A. R. S. 234- B, the new mineral leasing statute,
identifies the State's interest as the value of the royalty income
stream. It is not a percentage of the mine value or residual value
of the ore body as the Auditor General's report suggests.
The Department's appraiser defined the State's interest as the
net present value of the royalties received. We believe that this
is an appropriate definition consistent with the statute. The
appraisals of the State's interest in the two major copper mines on
Trust lands used this definition and were completed using standard
appraisal methology and rational assumptions.
A second requirement of the Department's appraisal contract
was to appraise the total mine. However, it is not necessary to
determine the value of the State's interest as the report suggests.
The value of the entire mining operation was determined in order to
assess the impacts any given royalty rate would have on the
economics of the mine, to establish costs consistent with the
economy of scale, and to determine the value of the mine to the
lessee.
The Department did not mistakenly accept these values as the
Auditor General's report suggests, but accepted the values as a
viable factor to be used in negotiating royalty schedules for the
mines as required by the statute. The mine appraisals provided
valuable information used by the Department in negotiating the
sliding scale royalty.
We believe that Finding I1 of the report misses the mark
because it focuses on an analysis of the mine appraisals, and the
net present value of the ore bodies. We recognized that the
appraisals could have been improved in some areas, but they were
sufficient for our purpose. Perhaps the best way to illustrate
what we are trying to say is to use the analogy of a building.
If the owner could sell a building, it would be vital to know the
value of the building. However, if the owner is precluded by law
from selling the building and can only rent the building, his
primary objective would be to determine a fair market rent.
Douglas R. Norton
March 5, 1992
Page 3
In the case of the mines, the State is precluded by law from
selling its mineral interest. The royalty, therefore, like a
building rent, is the only way that the State can capture its
interest. We believe that the $ 23.5 million in royalties we have
received from the ASARCO and Magma mines during the past four years
has already captured a major share of whatever appraised value is
assigned to the State's interest in these two mines.
We have three additional concerns about the report's analysis
of Finding 11. We believe that the concept that the Trust is to
receive no more or less revenue than it's share of the appraised
value of the ore body using a royalty is flawed. The only way to
ensure that this would happen is to make a cash sale. The net
present value of the ore body is the value of the ore after
recovery costs are deducted. A royalty that captured all of this
value would eliminate the mine's profit and would remove the
incentive for mining.
The Department hired, through the State procurement process, a
professional mineral appraiser to make the appraisals of the ASARCO
and Magma mines. We believe that it is inappropriate for the
Auditor General's report to make statements about what is
ttincorrecttiln the State appraiser's subjective opinion of value
without including the appraiser's response to the questions you
have asked him about what you perceive to be inadequacies in his
report.
We believe that Table I in the report is of no value even
though it is the basis for your conclusion. All it does is
unilaterally accept the consultantts values. Another appraiser
would almost certainly have a different value.
Further, the table is flawed because it attempts to add your
consultant's values generated as a percentage of the total ore body
with the Department appraiser's values generated from the net
present value of the royalty income. It then compares the total
with the appraiser's value. The result has no meaning because the
adjustments are related only to the value of the ore body, not the
value of the royalty income.
Findincf 111: The De~ artment Should Ensure that Future
Adjustments to it's Slidina Scale Rovaltv Formula are A~ pro~ riate.
The Department agrees with Finding 111, however, we disagree
with the recommendation that the Department should not allow
adjustments to the sliding scale formula based on annual production
costs.
Douglas R. Norton
March 5, 1992
Page 4
Some form of adjustment is necessary if a sliding scale is
used with the gross value of copper as the adjuster. The original
equities of the scale will be lost if inflation occurs impacting
either the production cost or copper price or both. The following
illustration is derived from one of the mineral leases.
The royalty calculations beginning with calendar year 1992, the
lower and upper CIP limits described in section 3.3~ as $ 1.10 and
$ 1.60 respectively shall each be adjusted either upward or downward
by an amount equal to the difference between the new five year
average production cost (" NFYAPC"), referring in this initial
adjustment to the five year period 1987- 1991 inclusive, and the
last five year average production cost ( LFYAPC), referring in this
initial adjustment to the five year period 1986- 1990 inclusive.
The formula for calculation of the lower CIP limit, where NLL
equals the new lower limit, PLL equals the previous lower limit ( in
this initial adjustment $ 1.10 cents), shall therefore be:
NLL = PLL + ( NFYAPC - LFYAPC)
As you can see the adjustment factor is an index. The base
number is adjusted in both directions, upward and downward by this
index. The base is not directly adjusted to last year's costs as
suggested by the report. Numerous indices were considered. We
believe the one chosen to be appropriate because it is based on
factors specific to the mine rather than on indices only remotely
related to mine costs.
Findins IV: Improvements Needed for Plannins and Manasement
of the Mineral Lease Prosram.
The Department agrees with Finding IV. To this end, the
Department has prioritized the appraisal effort toward the small
producing mines. The appraisal of non- producing mineral leases is
also in process. Completion of all mineral lease appraisals is
expected by December 31, 1992.
In summary, we believe that the Department has adopted an
innovative sliding scale royalty, based on an index that reflects
gross value copper prices and mining costs, that is fair to both
the Trust and the mineral lessees and that is more advantageous to
the Trust than other royalty schedules we have found in the market
place.
The royalty schedules that the Department has applied to the
Magma and ASARCO mineral leases have captured over $ 12 million in
additional royalties, and total royalties of $ 23,251,021, from
these two mines during the 1988- 1991 period. These schedules will
continue to produce a fair return to the Trust that is
Douglas R. Norton
March 5, 1992
Page 5
substantially greater than would have been received under the old
fixed rate royalty based on net value of minerals produced. We
also expect these royalty schedules to capture much more than the
present appraised value of the State's interest in these two mines.
The report contains suggestions for changes that will improve
the overall quality of the Department's minerals management
program. We will implement these changes.
Thank you for the opportunity to comment on this report.
Sincerely,
M. J. ~ asseli
MJH : dcd